Employment Settlement Subject to Taxation; Did Not Qualify For Section 104(a)(2) “Personal Physical Injuries or Physical Sickness” Exclusion

Taxes. The second thing in the oft-quoted sardonic/cynical short list of things that are certain in this life.

If and when the settlement of an employment discrimination claim is discussed, consideration must be given to the tax implication of any such settlement, both to the payor employer and payee employee. (For this purpose a tax professional, such as a CPA or tax attorney, which I am not, should be consulted.)

One provision of the Tax Code, 26 U.S.C. 104(a)(2), is often invoked in this scenario. That statute provides, inter alia, “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 or physical sickness”

In Stassi v. Commissioner of Internal Revenue, 2021 WL 423081 (U.S. Tax Ct. 2021), the court assessed the issue of whether any part of an amount of money – $69,650, identified on a Form 1099-MISC as nonemployee compensation – received in the settlement of a lawsuit against her former employer was excludable from income under section 104(a)(2).

Unfortunately for the petitioner taxpayer/employee, the answer was “none.” The court explained:

To justify exclusion from income under section 104(a)(2), the taxpayer must show that his or her settlement proceeds were in lieu of damages for physical injuries or physical sickness. See Green v. Commissioner, 507 F.3d 857, 867 (5th Cir. 2007), aff’g T.C. Memo. 2005-250; Bagley v. Commissioner, 105 T.C. 396, 406 (1995), aff’d, 121 F.3d 393 (8th Cir. 1997). The nature of the claim that was the actual basis for settlement guides our determination of whether such payments are excludable from income. See Burke, 504 U.S. at 237. In evaluating the nature of the underlying claim, a key question to be asked is: “In lieu of what were the damages awarded?”

The determination of the nature of the underlying claim is factual and is made by considering the agreement in the light of all the facts and circumstances, including the claim’s characterization under applicable State law, the evidence marshaled, the arguments made by the parties, and the intent of the payor of the settlement. Threlkeld v. Commissioner, 87 T.C. 1294, 1306 (1986), aff’d, 848 F.2d 81 (6th Cir. 1988). In this case the parties reached a settlement agreement, bringing the settlement payment under the initial definition of “damages”. See sec. 1.104-1(c), Income Tax Regs. Respondent contends that petitioners did not satisfy the further requirements of section 104(a)(2) because the settlement payment at issue was not made on account of personal physical injuries or physical sickness. Petitioners contend that the inclusion in the settlement agreement of the words “physical manifestations” establishes that the payments were for physical injury or sickness. The demand for damages that petitioner wife’s attorney sent to Vident made no mention of personal physical injuries or physical sickness, referring only to “Wage and Hour”, “Constructive Termination”, and a multiplier for “Emotional Distress and Punitives”.

Petitioners failed to prove a causal link between the claims against Vident and petitioner wife’s shingles. See Goode v. Commissioner, T.C. Memo. 2006-48. Petitioners provided evidence that petitioner wife suffered from shingles, but they did not provide evidence that established that the occurrence of her shingles was related to or caused by her employment at Vident. Because petitioner wife did not file a complaint based on physical injury or sickness and the settlement agreement did not state that the payment was in lieu of damages for physical injury or physical sickness, the $69,650 settlement payment is not excludable pursuant to section 104(a)(2).

This decision illustrates the importance of careful consideration of tax issues when resolving an employment discrimination case via settlement.

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