IRS Says Fen-Phen-Related Tests Not Taxable

The IRS’ ruling came in response to an inquiry from a Philadelphia law firm, which is handling the settlement of a class-action lawsuit over allegations that consumers suffered heart trouble by taking fen-phen diet drugs, according to a Legal Intelligencer news report.

The issue about the tax status of medical monitoring is a significant one in the diet drug case because many class members are receiving only the free echocardiograms. The tests are being performed to determine if they have suffered any damage to their heart valves.
If taxes were to be imposed, the $800-echocardiogram could generate a $300 tax bill. Lawyers administering the settlement said they feared recipients might forgo the test if taking it would lead to a bill from Uncle Sam.

The IRS was apparently swayed by the arguments. The private letter ruling states that refunds paid to class members for the costs of the drugs is not “gross income” and not taxable.
But that ruling was based on two assumptions — that the class member did not deduct the cost of the drug in a prior tax year, and that the refund did not exceed the original amount paid for the drugs.

So, the IRS held, the lawyers administering the settlement have no duty to report the exam repayments to the IRS or to withhold taxes.

Payments Not ‘Income’

In trying to convince the IRS to rule the way it eventually did, the lawyers running the settlement argued that personal injury law in many states already provides that the need for medical monitoring is a compensable “injury.”

The lawyers urged the IRS to rule that the need for medical monitoring should be characterized as a personal physical injury and, therefore, that benefits paid in a medical monitoring class action are exempt from income taxes. 

But even if the IRS characterized it as an “economic injury,” they argued that it should still be tax-exempt since they cannot be considered “income.” 

“Regardless of how the medical claim is characterized for tax purposes, the economic fact is that the class members … are merely being restored to the economic position they would have been in had the diet drugs been safe,” the lawyers wrote.