Fen-Phen/Redux fraud = taxable income

[newbie]

I too thought this was interesting:

Someone on a different tax board said he was double-checking to be sure a payment to a client under the Fen-Phen/Redux settlement was non-taxable and ran into an unusual set of circumstances. He said he noticed an article that said two people who lied in claiming they took the drugs and received settlements were charged with failing to report the income on their tax returns. His first reaction was that these payments were non-taxable, so how could the recipients be taxed on the payment? The article went on to explain that the nature of the payment changes to taxable income since it was obtained through fraud.

This was a news article and it didn't get into the technicalities, although it did say they were ordered to forfeit property bought with the proceeds and were facing a $100,000 fine, plus jail time. This wasn't a small matter - they got $250,000 in the settlement, which worked out to $150,000 after paying the lawyers.

[Bees Knees]

fraud is irrelevant

TTB, page 3-20 says “Compensatory damages received for personal physical injury or sickness are not taxable, including damages for loss of wages or earnings, loss of earning capacity, and for emotional distress caused by a physical injury or sickness. Compensatory damages are amounts paid to compensate for actual loss or injury.”

You will note that nontaxable settlements can include compensatory damages for loss of wages or earnings, which would otherwise be taxable if it were not for the fact it is on account of physical injury or sickness.

In the case you cited, people received some kind of settlement for some kind of physical injury or sickness, making the settlement non-taxable. If it was determined later that a few individuals were not really physically injured or sick, the settlement is no longer tax-free. It is irrelevant that it was due to fraud. It could also simply be an honest mistake, or wrong interpretation of what is a physical injury or sickness. The code excludes the settlement when it is on account of physical injury or sickness. If they weren't physically injured or sick, and received a settlement for whatever reason, it’s taxable.

[JohnH]

Fraud not totally irrelevant

Agreed that the setttlement becomes taxable in the absence of physical injury or sickness regardless of the surrounding circumstance, but the fraud produced a host of other problems for them. The other angle on this issue concerned the fact that the perpetrators were assessed substantial fines and have to forfeit property obtained with the proceeds from the fraud. So not only did they have to pay tax on the money obtained by fraud, they could not get any sort of tax relief from the forfeiture of the property and they could not offset the fines against the income reported. Not to mention that some of them faced jail terms of up to 5 years.

[Jesse]

If they got $250,000 in the settlement, which worked out to $150,000 after paying the lawyers my guess is that they were out the $100,000 lawyer fee also unless the lawyer was involved in the fraud scheme.

So now they will have to pay big time:

+$250,000 settlement received
($100,000) original payment to lawyer
($100,000) fine
($250,000) settlement repayment
($XXX,XXX) income taxes
=OUCH!!!!!!

That's an expensive lesson for sure.

[JohnH]

The Lesson

I suppose the lesson here would be: if you're going to choose to be a thief, be a smart thief.
Never steal more than you can afford to repay on an after-tax basis.