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Lessons from the Tax Court: No tax break for egg donor

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Generally, damages compensating you for a physical injury or illness (other than punitive damages) are exempt from income tax, including amounts attributable to pain and suffering. For instance, if you receive a legal settlement arising from physical injuries ­suffered in a car accident, you don’t have to pay tax on the award.

However, in a new case, the Tax Court ruled that the payments to an egg donor for pain and suffering were taxable. (Perez, 144 TC No. 4, 1/22/15)

Facts of the new case: Ms. Perez entered into a contract with an agency to be an egg donor. Under the contract, she would be paid for her time, effort, inconvenience, pain and suffering in donating her eggs. The contract also provided that Perez would assume all medical risks. A similar contract between Perez and the intended parents established that the payments constituted consideration for her pain, suffering, time, inconvenience and efforts.

After signing the contracts, Perez started a battery of tests and examinations, including hormonal injections. The injections often bruised and hurt her. She also suffered headaches, nausea and fatigue from the procedures.

Perez received a total of $20,000 from the agency in 2009. She didn’t report any of this amount as income on her 2009 tax return.

Both parties agreed that the payments weren’t for the sale of the eggs. But Perez argued that she was paid in exchange for the pain, suffering and physical injuries she endured as part of the egg-retrieval process. Conversely, the IRS maintained that she was simply being compensated for services rendered.

Under the prevailing regulations, any damages received (other than punitive damages), whether by lawsuit or agreement, are exempt from tax if they are paid on account of personal physical injuries or physical sickness. (IRC Regu­­la­­tion Sec. 1.104-1(c)) The IRS has interpreted this test to distinguish damages for personal injuries from, say, damages for breach of contract.

Tax outcome: The Tax Court determined that the injuries Perez suffered were within the scope of the medical procedures to which she had consented. Any physical pain was a byproduct of performing the services identified in the contracts. Thus, the payments are treated as compensation for services rendered.

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