Settlement Includable in Income; Agreement Failed to Specify if Personal Injuries Were Physical

(Parker Tax Publishing September 2022)

The Tax Court held that no part of a legal settlement received by a taxpayer from a company that he worked for was excludable from income because the agreement signed by the parties contained no terms indicating that the payment by the company was made on account of physical injuries or physical sickness. The court noted that, while the settlement agreement provided for a payment to the taxpayer to compensate him for alleged personal injuries, it did not specify whether those injuries were physical. Dern v. Comm'r, T.C. Memo. 2022-90.

Background

From the early 1990s to March 2016, Thomas Dern worked as a sales representative for P.F.I., Inc. (PFI), a manufacturer and distributor of paint and paint-related products. Dern sold PFI's products in exchange for a commission, health insurance, and a $500 travel stipend pursuant to a sales representative agreement with the company.

On September 19, 2015, Dern was hospitalized for acute gastrointestinal bleeding and a resulting heart attack. Dern's acute gastrointestinal bleeding was unrelated to his work for PFI. Although his initial hospital stay lasted for three days, Dern was intermittently hospitalized over the next few weeks. Accordingly, he was unable to perform his sales duties for PFI during October and November 2015. In December 2015, Dern resumed his sales duties but did so by email and phone in lieu of in-person sales calls. The following month Steven Holst, an officer of PFI, asked Dern to resume making in-person sales calls. However, apart from one date in January 2016, Dern continued to perform modified sales duties by email and telephone. On January 27, 2016, PFI notified Dern that it was terminating their sales representative agreement. The letter stated: "[Y]our prolonged health conditions have unfortunately had a significant impact on your ability to effectively represent the Company and perform the duties of a sales representative."

Subsequently, Dern retained an attorney to represent him in a lawsuit against PFI, Holst, and other affiliated entities (collectively, PFI defendants). The lawsuit alleged the following causes of action: (1) willful misclassification in violation of California Labor Code Section 226.8; (2) disability discrimination in violation of the California Fair Employment and Housing Act (California FEHA), California Government Code Section 12940, et seq.; (3) failure to accommodate disability in violation of the California FEHA; (4) failure to engage in the interactive process in violation of the California FEHA; (5) age discrimination in violation of the California FEHA; (6) failure to take all reasonable steps to prevent discrimination in violation of the California FEHA; (7) wrongful termination in violation of public policy; (8) intentional infliction of emotional distress; (9) failure to timely pay all wages upon separation from employment; and (10) breach of contract.

In 2017, Dern and the PFI defendants agreed to settle all claims, which they memorialized in a settlement agreement and mutual release of claims (settlement agreement). Under the settlement agreement, the PFI defendants agreed to pay $550,000 (gross settlement) "to compensate [Dern] for alleged personal injuries, costs, penalties, and all other damages and claims." Further, the agreement provided that it was "for and on account of [Dern's] claims alleging compensatory damages, emotional injuries, penalties, and punitive damages." The settlement agreement also included a general release of claims which was "intended to include in its effect, without limitation, all claims known or unknown at the time of the execution" of the settlement agreement. On September 8, 2017, after deducting attorney's fees and costs such as filing fees, Dern's attorney sent him a check for $327,416.

Dern's attorney filed Form 1099-MISC, Miscellaneous Income, with the IRS reporting nonemployee compensation of $330,000 (gross settlement of $550,000 less attorney's fees of $220,000). On April 15, 2018, the IRS received 2017 joint Form 1040, U.S. Individual Income Tax Return, from Dern and his wife. Thereon, the couple reported nonemployee compensation of $6,000 pertaining to an appraisal business. They did not report as income any part of the gross settlement.

In January of 2020, the IRS issued a notice of deficiency to Dern and his wife for 2017. According to the IRS, on the basis of the Form 1099-MISC issued by Dern's attorney, the couple had unreported nonemployee compensation as a result of the settlement. The couple argued that the settlement payment was received for personal physical injuries and personal physical sickness and was thus not taxable under Code Sec. 104(a)(2). They contended that the settlement fell within the provisions of Code Sec. 104(a)(2) because Dern's physical illness caused PFI to terminate him.

Code Sec. 104(a)(2) provides that 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. For these purposes, emotional distress is not treated as a physical injury or physical sickness. Reg. Sec. 1.104-1(c) defines the term "damages" as "an amount received (other than workers' compensation) through prosecution of a legal suit or action, or through a settlement agreement entered into in lieu of prosecution." The taxpayer is required to prove that the damages were received on account of physical injuries or physical sickness. There must be "a direct causal link" between the damages received and the physical injury or sickness sustained.

Analysis

The Tax Court held that, because the settlement agreement contained no terms indicating that PFI issued the settlement payment on account of Dern's physical injuries or physical sickness, the amounts received by the Derns was taxable. The court noted that while the settlement agreement provided for a payment "to compensate [Dern] for alleged personal injuries," it did not specify whether those injuries were physical. Instead, it provided for a broad general release by Dern of "all claims known or unknown." This general release, the court observed, did not specifically allocate any part of the settlement agreement to personal physical injuries or physical sickness and thus the nature of Dern's claim cannot be determined from such a release.

In the absence of an express statement of what the settlement proceeds were intended to compensate, the court said it had to consider the intent of the payor on the basis of all facts and circumstances in this case. The settlement agreement, the court noted, provides that the payment was made "to compensate [Dern] for alleged personal injuries, costs, penalties, and all other damages and claims." However, the court observed, Dern's complaint alleged only violations of California's labor and antidiscrimination laws, wrongful termination, breach of contract, and intentional infliction of emotional distress. Since Dern did not assert any claims premised upon physical injury or illness, the court said it could not conclude that the PFI defendants intended to compensate Dern for any such injury or illness.

With respect to the couple's argument that the settlement fell within the provisions of Code Sec. 104(a)(2) because Dern's physical illness caused PFI to terminate him, the court noted that Code Sec. 104(a)(2) requires a "direct causal link" between Dern's illness and the settlement payment and the couple failed to prove such a link. While they provided evidence that Dern was physically ill, the court said they failed to provide evidence that PFI caused or exacerbated his illness. To the contrary, the court noted that the couple stipulated that Dern's acute gastrointestinal bleeding was unrelated to his work for PFI. Thus, because PFI did not compensate Dern for physical injury or physical sickness, the settlement payment was not excludable pursuant to Code Sec. 104(a)(2).

For a discussion of the exclusion from income of payments received on account of damages received on account of personal physical injuries or physical sickness, see Parker Tax ¶75,910.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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