Taxation of Litigation Settlement Proceeds: Mere Words are Not Enough

Take-Away: Amounts received in settlement of litigation can be subject to income tax if not clearly identified as paid on account of physical injuries or physical sickness. Just saying the amount received was attributable to the recipient’s physical injury or sickness will not cut it.

Background: Gross income includes all income from whatever source derived unless it is expressly excluded by the Tax Code. [IRC 61(a).] The Tax Code interprets taxable income broadly. Exclusions from taxable income are narrowly construed. A taxpayer must show that their receipt clearly falls within the scope of one of the statutory exclusions from taxable income. Commissioner v Schleier, 515 U.S. 323 (1995).

• Physical Injury or Physical Sickness: One exclusion from gross income is the ‘amount of damages (other than punitive damages) received by lawsuit or agreement, and whether paid in a lump sum or in periodic payments, on account of personal injuries or physical sickness.’ [IRC 104(a)(2).] The recipient is required to prove that his or her damages received were on account of their physical injuries or sickness. Specifically, there must be a direct causal link between the damages received and the physical injury or sickness sustained. The nature of the claim that was the actual basis for the settlement will guide the Tax Court’s determination of whether the payments are excludible from taxable income. The ‘test’ the Tax Court applies asks the question: In lieu of what were the damages awarded?
• Damages: Damages are described as an amount received, other than worker’s compensation, through prosecution of a legal suit or action, or through a settlement agreement entered into in lieu of a lawsuit.
• Emotional Distress: Emotional distress damages are not treated as a physical injury or physical sickness. The Legislative History to IRC 104(a) notes: “It is intended that the term emotional distress includes symptoms, (e.g. insomnia, headaches, stomach disorders) which may result from such distress.” [1996-3 C.B. 74, 1041.]
• Factual Determination: The Tax Court will look to the nature of the underlying claim, the claim’s characterization under state law, arguments made by the parties, and the intent of the payor to determine if the settlement amount paid as ‘damages’ satisfies one of the statutory exclusions from taxable income. Choice of words or labels used in the settlement agreement  will not be enough.

These basic principles were applied in a recent Tax Court decision that held that the recipient was liable for income taxes on the amount that she received in a settlement from her former employer.

Tax Court Case: Stassi et ux v. Commissioner, No. 4179-18S, Tax Court Summary Opinion, 2021-5 (February 8, 2021)

• Facts: The Petitioner [no name was given so let’s call her Willa] was employed as a Human Resources Assistant at Vident, from July of 2011 until her resignation in January 2015. In early 2014 Willa was diagnosed with shingles. 5 months later Willa was placed on a 30-day improvement plan at work. A couple of days later, Willa went on unpaid leave of absence until her resignation the following January. Shortly after Willa was put on her unpaid leave of absence, she sent a letter to Vident’s Board of Directors in which she complained about the work environment at Vident; in her letter though, Willa never mentioned any physical injury or sickness. About a month before Willa’s resignation, she had her attorney send Vident a letter demanding damages for  “Wage and Hour violations, Constructive Termination, and Emotional distress and Punitives.’

Less than 3 months after her resignation, Willa and Vident entered into a settlement agreement, which provided that Willa would receive $80,000. That agreement recited that the payment was in settlement for Willa’s claims that she was ‘owed wages, that she was constructively discharged, that she was retaliated against for making complaints, and that she suffered emotional distress with physical manifestations of the same.’ The words ‘physical manifestations’ had not been used in Willa’s initial complaint filed with Vident; the words were inserted in the settlement agreement during its negotiations.

Willa and Vident agreed that $10,350 of the $80,000 settlement proceeds would be designated as ‘consideration for lost wages’ and that Vident would issue to Willa a W-2 for that amount. The remaining $69,650 was described in the agreement as ‘consideration for physical manifestations of [Willa’s] emotional distress claims’ and that Vident would issue to Willa a 1099-MISC with respect to that amount. Two separate checks for these amounts were issued to Willa by Vident.

Willa reported the $10,350 on the jointly filed 2015 Form 1040 income tax return that she and her husband filed. Willa reported on that same return $1.00 of the remaining $69,650 as ‘other income.’ Willa attached to her 2015 Form 1040 a statement from her tax return preparer and a letter from her attorney with regard to the settlement agreement.

The IRS issued Willa and her husband a notice of deficiency in the amount of $15,981 for their 2015 Form 1040 income tax return. This led to the couple filing a Petition with the Tax Court.

Tax Court Decision: As noted earlier, the Tax Court judge decided against Willa. The judge found that Willa should have included the entire settlement amount in her reported taxable income for 2015.

Willa claimed that by including in the settlement agreement the words ‘physical manifestation’ that alone established that the payments that she received were for her physical injury and sickness. The judge responded that in his demand for damagesthat  Willa’s attorney sent to Vident, he only referred to Wage and Hour, Constructive Termination, and a multiplier for Emotional Distress and Punitives. There was no mention in the attorney’s letter with regard to Willa’s ‘injury or sickness.’

The judge also noted that Willa had failed to prove a causal link between her claims against Vident and her shingles. While she did provide evidence of her shingles, Willa did not provide any evidence that the occurrence of her shingles was related to, or caused by, her employment at Vident.

Because Willa did not file a complaint with Vident based on her physical injury or sickness, and her settlement agreement with Vident did not state that the payment was in lieu of damages for any physical injury or physical sickness, the $69,650 payment that she received was not excludable from her income under IRC 104(a)(2).

Conclusion: Merely injecting ‘magic words’ like ‘physical injury or physical sickness’ into a settlement agreement will not be enough to avoid paying income taxes on the settlement amount. As the reported case shows, the Tax Court will look closely at all of the underlying facts, and ultimately require the recipient to meet his or her burden of proof that the amount received falls within one of the statutory exclusions from taxable income. The risk in playing the ‘word game’ in settlement agreements is that the recipient may also face paying underreported penalties and interest if the IRS takes a close look at the underlying facts, as it apparently did in Stassi.