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Tax Talk with George Saenz

Ask the tax adviser

Taxes on an inherited court settlement

Dear Tax Talk,
My father died in 2000 as the result of ingestion of a prescribed drug, which was later removed from the market. My mother filed a lawsuit in 2002. She died later that same year. As executor of her estate, I recently signed an out-of-court settlement. The drug company states that the settlement is specifically for personal injury. None of the settlement is for punitive damages. I know that under IRS code section 104 that the settlement amount would not have been taxable to my mother. As her heir, is this settlement money also nontaxable to me or must it be run through her estate/probated will? If that is the case, I will have to pay inheritance taxes as the total amount of her estate would then exceed the $1 million maximum.

Is there any way that I can avoid paying the government this tax. Do I, as the person who is receiving the settlement have the right not to be taxed because the settlement was "on account of personal physical injuries or physical sickness." Punitive damages were not awarded. I have asked numerous CPAs and tax attorneys and no one seems to be able to give me an answer. Please help!
Thank you,
Susan

Dear Susan:
You've done a great job of expressing a difficult situation. Your problem falls within two different areas of the tax law: income and estate tax.

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From an income tax perspective, section 104 of the law excludes the settlement from income as it was because of wrongful death. The money would not have been taxable for income tax to your mother and similarly it is not taxable to you as her heir.

From an estate tax perspective, the settlement is an asset of her estate, as was the claim. In 2002, estates valued at less than $1,000,000 were not subject to estate tax and were not required to file an estate tax return. Unlike income tax, estate tax applies to the value of assets of a decedent, not the nature of the assets. In estate tax there are rarely any exclusions of assets as there might be for income tax purposes. For example, the face amount of life insurance is exempt from income tax, but is an asset subject to tax for estate tax.

Since you did not file an original return, you'll need to file a late return reporting all the assets of your mother and pay the estate tax due accordingly. Since the return is late (assuming she died more than nine months ago) you will be subject to substantial penalties for late filing (5 percent of the tax per month to a maximum 25 percent).

I recommend that you find a qualified CPA in your area to represent you in this matter, prepare an accurate return and negotiate the waiver of the penalties.

-- Posted: Aug. 14, 2003

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The complicated job of an executor
Estate planning starter kit
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Tax glossary
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