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Understanding insurance bad faith and other important issues - II

In a previous post, we discussed how the failure on the part of an insurance company to fulfill its duties to defend and indemnify may be grounds for an insurance bad faith lawsuit. Specifically, we discussed how aggrieved policyholders can pursue either first-party claims -- failing to settle claims in good faith -- or third-party claims -- failing to settle third-party claims within policy limits in good faith.

We also started discussing how one question that people naturally have when considering whether to pursue legal action against an insurance company is whether any recovery realized through the litigation would be subject to federal taxation. We'll examine this question in greater detail in today's post.

While people would understandably like a definitive answer as to whether awards or settlements secured in insurance bad faith litigation are taxable, this simply cannot be done. The reality is that just like many legal scenarios, the answer is that it depends.

Experts indicate that the existing body of law on the topic at least seems to establish several firm guidelines, including:

  • If the settlement or award can be properly viewed as compensatory damages for physical injuries or illness, and the bad faith litigation in question relates back to these damages, there's a good chance the money can be tax-free.
  • If the settlement or award derives from a claim relating to a disability or health insurance policy, the issue of taxation will depend largely upon who paid the premiums.

To illustrate the first point, consider one case in which a plaintiff was able to secure $30,000 as part of a class action settlement with his insurance company stemming from physical injuries claims. Here, the plaintiff excluded the entire amount from his income under Section 104 of the federal tax code, known as the physical injury exclusion.

The IRS challenged this exclusion, arguing that the class action lawsuit was for breach of contract, not physical injuries. The Tax Court, however, held that it was the nature of the plaintiff's claim that was controlling, such that despite the lawsuit revolving around an alleged breach of contract, his claim could be viewed as relating back to his personal injuries and that his exclusion from income was therefore valid.

To illustrate the second point, consider a case involving a plaintiff who filed a bad faith lawsuit after his claim for long-term disability relating to a major illness was rejected by the insurance company. The case ultimately settled for $65,000 and the plaintiff excluded the entire amount under Section 104.

The IRS disagreed and ultimately prevailed. Here, it was found that even though amounts received through accident or health insurers for personal injuries or illness can be excluded from income, this is not the case where premiums are paid by the insured's employer.

As complex as this issue is, it should in no way deter anyone from feeling as if they are without options for holding an insurance company accountable when it has failed to fulfill its obligations. Indeed, a skilled legal professional can answer your questions, explain the law and pursue justice.

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