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A US citizen recieves German Contergan Foundation Act payments

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A US citizen recieves German Contergan Foundation Act payments for thalidomide damage for birth defects. Are these payments taxable to the US citizen?
Submitted: 1 year ago.
Category: Tax
Expert:  Lev replied 1 year ago.

 

Lev :

Hi and welcome to Just Answer!
In general - such payments are classified as a foreign annuity and are taxable in the US.
According to the US-Germany tax treaty - payments are taxed only in the state of residency.
See for reference - http://www.irs.gov/pub/irs-trty/germany.pdf
page 25 - ARTICLE 18 Pensions, Annuities, Alimony, and Child Support

2. Subject to the provisions of Article 19 (Government Service; Social Security), annuities derived and beneficially owned by a resident of a Contracting State shall be taxable only in that State. The term "annuities" as used in this paragraph means a stated sum paid periodically at stated times during a specified number of years, under an obligation to make the payment in return for adequate and full consideration (other than services rendered).


For the purposes of this Convention, the term "resident of a Contracting State" means any person who, under the laws of that State, is liable to tax therein by reason of his domicile, residence, place of management, place of incorporation, or any other criterion of a similar nature.

Where an individual is a resident of both Contracting States, then he shall be deemed to be a resident of the State in which he has a permanent home available to him; if he has a permanent home available to him in both States, he shall be deemed to be a resident of the State with which his personal and economic relations are closer (center of vital interests).
Thus if the US citizen is a resident of Germany - such payments are not taxable in the US - and may only be taxed or not in Germany based on local laws.
If however - he/she is a resident of the US - payments are included into taxable income as foreign annuity. If there are any income tax liability depends on many items - total income, filing status, deductions, etc.

 

PS

It might be possible to treat such payments as compensatory damages for personal injury. However - there is no established practice and it is not clear if the IRS accepts such classification.

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Expert:  Lane replied 1 year ago.


Hi,

Different expert here.

I completely disagree.

I disagree, both, that this should be classified as a foreign annuity, or that this is a tax treaty issue at all.



This is an indemnification payment. Designed to make whole, those suffering physical damages for birth defects caused by thalidomide taken by expectant mothers to ease the symptoms of morning sickness. Unfortunately, Thalidomide often deformed the fetus.




The 1996 italicized additions to 26 USC § 104 - Compensation for injuries or sickness make this clear:

Gross Income DOES NOT INCLUDE...

"The amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries and physical sickness." are not included in income.

The only exception in which punitive damages are tax-free occurs when such damages are received in a wrongful death action if the applicable state law allows only punitive damages to be awarded in a wrongful death action.

By adding the word "physical" twice, Congress disqualified damages that did not have their origin in a physical injury or physical sickness, such as employment discrimination or injury to reputation claims

Birth Defect Claims, regardless of the source or the form of the payment are indemnification payments that are made to make damaged persons whole, indemnify.




In terms of understanding the logic for this law, Under the IRS' doctrine of Substance over Form, this does not represent an increase in Net Wealth, hence is not taxable income.



These payments are not taxable to US citizens.



Let me know if you have questions...

Lane

(Positive feedback appreciated, that's how we're paid here)
Expert:  Lev replied 1 year ago.
regarding different opinion...

As I mentioned above - it might be possible to treat such payments as compensatory damages for personal injury. However - there is no established practice and it is not clear if the IRS accepts such classification.
Such classification might be based on section 104 - http://www.law.cornell.edu/uscode/text/26/104
... gross income does not include—
(2)the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness;
I am afraid that payments include compensation for punitive damages - payments may not be clear divided between punitive damages and physical injuries damages that is required under the US law to exclude from taxable income.
While that is possible - there is no established practice and it is not clear if the IRS accepts such classification.
Expert:  Lane replied 1 year ago.

I would only add that what the IRS accepts is not the bottom line issue here.

What is legal here, is the issue. (Be aware of the difference between tax law and tax administration)

As you probably know, thalidomide damage was the impetus for the favorable tax treatment of payments for physical damage and sickness.

You should also note that if this were the result of a lawsuit for negligence in the US, section 104 requires that those states that would call this punitive, re-characterize it as physical/sickness damage, again, to be sure that those afflicted are not abused by the tax system.

You have a VERY good case for this NOT being included in taxable income. DO NOT be swayed by those on the front lines at IRS.

Get this to a reasonable judge if need be, either in tax court or federal district court.

The reason that 104 was amended was to be sure that even when third parties are the payee, the income is not considered taxable.

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