Couples who have difficulty conceiving often turn to alternate methods: in-vitro fertilization, surrogate mothers, and donated eggs or sperm. Each of these methods carries its own form of risk, and none of them come cheaply (of course, one wonders if about, oh, 13 years and any number of “I hate you,” “You suck” and “You never let me do anything I want to do” in, any of these parents will ask themselves if the cost was worth it).

In-vitro fertilzation aside, all of these options require a third person’s involvement, whether to supply the egg or sperm or the vessel for gestation. And no rational person will do this for a perfect stranger simply out of the goodness of their heart (and maybe not family, either, but we won’t go there today). Somehow, some way, money will be involved. After the jump, see how that can complicate matters.

Women who wish to donate eggs don’t really donate anything; they get paid for their eggs, the same as a surrogate mother gets paid for carrying a baby. Up until recently, most egg donors didn’t report the money they earned from the donation as income. Instead, they excluded it from income under 26 USC 104(a)(2), which excludes from gross income “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.”

Contracts for donors are carefully worded to avoid the appearance of selling body parts (illegal in many ways) or trafficking (also illegal). Generally, they state that the payment is in ‘consideration for pain, suffering,’ etc. Donors latch onto this language, and use it to support their claim that the payment is therefore ‘damages’ excludable from income.  But is it? Can you contract for damages before you incur damages?

To answer the second question, well, you can…kind of. Many contracts include liquidated damage provisions, which state, generally, that if the other party doesn’t perform, the first party will suffer some amount of measurable damages – the liquidated damage amount. But that’s not the case here. Here, the donor receives a sum whether or not they perform, with some exceptions. And if they provide non-conforming product (i.e., eggs that can’t be fertilized) they still get paid. So this isn’t really a liquidated damage type thing.

So what’s the answer? Well, funny you should ask, because the Tax Court recently considered a case on this very topic (hence this post). In Perez v. Commissioner (144 T.C. No. 4 (2015)), the Tax Court considered whether or not a payment to an egg donor was damages, excludable under Section 104(a)(2), or income (NOTE: the taxpayer in this case didn’t consult with a tax lawyer prior to signing or reporting/excluding the income. Instead, she chose to go online to donor listserves and seek tax advice there. Bad idea, as you’ll see). 

26 U.S.C. 61(a) is where we find the definition of gross income, and it says that gross income is “all income from whatever source derived, including (but not limited to) the following items: (1) Compensation for services, including fees, commissions, fringe benefits, and similar items…”

The court, after doing a rather thorough analysis of the facts, the law, and economic reality, determined that the payment was, in fact, taxable income. Although Judge Holmes (whom I’ve had the opportunity to meet outside of the court, and found to be a very down-to-earth, practical person) was very sympathetic to the pain and suffering that Ms. Perez went through, he simply – and correctly – found that there was no support for the argument that the payment was damages, because a) the contract predated the injury, b) Ms. Perez voluntarily agreed to under go the pain and suffering, and c) the pain and suffering were a natural consequence of the service for which she contracted (providing eggs for fertilization). As a result, it was a contract for services, and the income was taxable. To find otherwise would open the door for other ‘damages’ claims – for example, football players such as Ndamukong Suh who might exclude a large portion of is new, $114 million contract as ‘damages’ for injuries he might receive on the field (damages he causes to other players through his penchant for stepping on them is a different issue).

What does this decision mean for surrogate mothers and sperm donors? Simple – it means that the money that they receive for providing those services (carrying a child or providing sperm) is taxable income. Arguably, if part of a payment to an egg donor or a surrogate mother is to reimburse for medical expenses, that part can be deducted as a medical expense, but it also has to be included as income – making it a wash at best. There simply is no way for a potential donor or surrogate to fashion an argument that these payments are compensation for damages, when pain and suffering are a natural consequence of providing an egg, a womb, or sperm.