Tax Update

Two recent cases highlight the limitations on an individual taxpayer’s ability to exclude money received in a lawsuit settlement from gross income, and provide insight on when a potential exclusion is warranted. The IRS and courts focus on the underlying nature of the harm that is being alleged in the lawsuit and look to the “origin of the claim” doctrine to determine if a taxpayer can exclude a settlement payment from gross income in the year in which the settlement payment is received. The statute and the IRS view of the law is that a visible injury or illness must be present to argue for exclusion under Internal Revenue Code section 104.

Section 104(a)(2) and Treas. Reg. Section 1.104-1(c): Compensation for Injuries or Sickness

Section 104(a)(2) excludes from a taxpayer’s 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.” Damages paid for emotional distress are not excluded from income pursuant to section 104(a)(2), except in limited circumstances when treatment for the emotional distress is in connection with treatment for the physical injury or illness.1

After the statutory language was changed to require that the injury or sickness be a “physical” injury or sickness, the IRS, in at least one ruling,2 focused on what might be evidence of such a physical injury. In PLR 200041022 (July 17, 2000), involving a woman who alleged that she was sexually harassed, the IRS concluded that the injury must be visible in the form of a “cut, scrape, bruise, etc.”

Payments made to compensate a taxpayer for emotional distress — which can include pain and suffering manifested by headaches, stomachaches, etc. from such emotional distress — cannot be excluded from taxable income. These are highly subjective concepts, and, thus, the type of injury and a taxpayer’s ability to exclude a settlement payment from taxable income remains the subject of litigation. Two recent cases highlight the requirements and the types of injuries that will allow a taxpayer to exclude the settlement from income under section 104(a)(2).

Devine v. Comm’r, T.C. Memo 2017-111 (Jun. 13, 2017)

The taxpayer in Devine alleged sexual harassment and gender discrimination claims against her employer, the District of Columbia Air National Guard. The taxpayer’s attorney offered, and the National Guard agreed, to settle the claim for $225,000 plus attorney’s fees. The settlement letter explicitly referenced the taxpayer’s understanding that she was responsible for all U.S. federal and Maryland state taxes on the amount received. In addition, the taxpayer’s pleading did not mention a request for payments for any physical injury, even though she alleged in her testimony physical components to her injuries. When the taxpayer filed her Form 1040 for the year when she received the settlement payment, she did not include the amount of the settlement payment in gross income. She subsequently received a notice from the IRS regarding the underreporting of income on her 2012 tax return, claiming that tax and accuracy-related penalties were due.

The taxpayer argued that the settlement payment was for personal physical injury because the sexual harassment and pregnancy-based discrimination had a “physical component,” including unwanted touching and a “violent hug,” and, thus, could be excluded from gross income pursuant to section 104(a)(2).

The Tax Court disagreed, holding that, in the case of a settlement, the “nature of the claim” determines whether the damages are excluded under section 104(a)(2). Under the facts of the case, the Tax Court held, the taxpayer failed to establish that any portion of the settlement payments were for “personal physical injuries or physical sickness.” The court relied on the lack of any reference to physical injury or payment for physical injuries in the settlement agreement. Although the court acknowledged sympathy for the taxpayer’s position, it noted that the taxpayer, at no point in the proceedings, alleged physical injury or made any demand for compensation for any physical injury. In addition, the taxpayer did not provide medical documents indicating physical injury from the actions taken by her employer. As such, the Tax Court held that it was clear that the “intent of the payor” was to settle claims based solely on sexual harassment, gender discrimination and retaliation.

Rajcoomar v. Comm’r, T.C. Memo 2017-129 (Jul. 3, 2017)

The taxpayer in Rajcoomar was required to undergo several surgeries due to a car accident. As a result of his injuries and medical treatment, the taxpayer went on short-term disability leave at his job. When he was unable to return to work by the company’s deadline, he was fired. The taxpayer sued, alleging that his employer discriminated against him based on his disability. There were no allegations that taxpayer suffered any physical injury as a result of his improper termination. The dispute was settled for a monetary payment. The taxpayer included the proceeds from the settlement as additional wages on his 2013 tax return. In 2016, the taxpayer sought to reclassify his settlement payment under section 104(a)(2), and thereby exclude the settlement payment from his taxable income.

The Tax Court held against the taxpayer. The court concluded that the proceeds from the settlement agreement could not be excluded pursuant to section 104(a)(2) because the tax treatment of payments received under a settlement agreement is determined by reviewing the “nature of the claim.” Here, the taxpayer’s cause of action was based exclusively on state and federal provisions prohibiting discrimination on the basis of disability. The taxpayer failed to allege any physical injury or physical sickness for which the employer was liable in his complaint, his rebuttal to the employer’s response, or the settlement agreement.

Although the taxpayer alleged at trial that his employer’s discrimination caused him headaches, he did not submit any medical documentation. In addition, the settlement agreement did not reference payments in settlement of any stated physical injuries that resulted from the discrimination by his employer. Thus, the court concluded that the taxpayer was not able to reclassify his settlement payment as excludable on account of a personal physical injury as required by section 104(a)(2).

Pepper Perspective

In each case, the necessary components of section 104(a)(2) were absent and, thus, barred the taxpayer from excluding the settlement payments from income. The Tax Court noted in both cases that neither the settlement agreements nor the court pleadings explicitly provided facts or documentation related to actual physical injury or physical sickness. Thus, because the taxpayers did not allege or document any physical injury or physical sickness and did not agree to a settlement agreement that compensated them for any physical injury or physical sickness, no portion of the recovery could be characterized as compensation for a physical injury or physical sickness.

These cases demonstrate the intense factual scrutiny given to a claim under section 104, and highlight the importance of drafting complaints and settlement agreements to include all factual bases for liability, including, if applicable, any physical injury or physical sickness suffered. In cases in which physical injury or physical sickness is present, the portion of the settlement amount being paid to compensate the taxpayer for these physical injuries and/or physical sicknesses should be specifically designated in order to assert that, under section 104(a)(2), this portion can be excluded from income. In Devine, some of the settlement payment possibly could have been excluded if the “violent hug” had resulted in injuries to the taxpayer that she described in her discrimination complaint and settlement agreement.