Taxpayers initiate lawsuits for a variety of reasons. For example, a taxpayer may bring a lawsuit against a defendant for breach of contract, personal negligence, defamation, or for a litany of other claims. Believe it or not—these individualized claims have significance for federal income tax purposes.
As a general matter, lawsuit recoveries (whether through judgment or settlement) are deemed fully taxable to the recipient. Indeed, there is a presumption under well-established federal case law that the receipt of a damage recovery is taxable. The taxpayer must therefore rebut the presumption and demonstrate that, for one reason or another, the recovery is not taxable.
In many of these instances, taxpayers commonly point to a statutory exclusion from gross income under section 104(a)(2). Under that provision, certain damages related to “personal physical injuries or physical sickness” are excluded from gross income—i.e., those damages are not taxable. Because damage awards outside the scope of section 104(a)(2) are generally taxed at ordinary income tax rates, taxpayers who can prove that their damages fall within the purview of section 104(a)(2) can reap significant tax savings.
Of course, the IRS knows this as well. Accordingly, in many cases, the IRS simply waits until after the taxpayer files a tax return for the year in which the damages are paid and matches the return reporting with the information return issued by the defendant (e.g., IRS Form 1099), examining the return to see if the payment was reported in full. If there is a mismatch in the information return reporting and the tax return, the IRS selects the return for examination.
When the examination occurs and the taxpayer raises section 104(a)(2), the IRS will try to determine the payor’s intent. For federal income tax purposes, the payor’s intent is often gleaned from the terms of a settlement agreement if one has been entered into amongst the parties. But exactly how precise does the language need to be to convince the IRS or the courts that the payment falls within section 104(a)(2)? This issue is litigated often, but the best answer is usually the clearer the better. As shown in the recent Tax Court decision in Dern v. Comm’r, T.C. Memo. 2022-90, taxpayers who fail to adequately specify the purpose of the settlement payment do so at their own peril.
Facts in Dern
Thomas Dern (Mr. Dern) worked as a sales representative for PFI, Inc. (PFI), a manufacturer and distributor of paint and paint-related products. In September of 2015, Mr. Dern was hospitalized for acute gastrointestinal bleeding and a resulting heart attack. Because Mr. Dern was hospitalized off and on for several weeks, he was required to perform his sales duties by email and phone in lieu of in-person sales calls.
During this period of time, an officer of PFI asked Mr. Dern to resume making in-person sales calls. When Mr. Dern continued to perform his sales duties by email and phone, PFI notified him that it had terminated his sales representative agreement. PFI’s letter in this regard 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.”
After receipt of the letter, Mr. Dern hired an attorney to represent him in a lawsuit against PFI for the following causes of action: (1) willful misclassification in violation of California Labor Code § 226.8; (2) disability discrimination in violation of the California Fair Employment and Housing Act (California FEHA); (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 under separation from employment; and (10) breach of contract.
As happens in most lawsuits, the parties settled. The settlement agreement was memorialized in a settlement agreement and mutual release of claims. Under the terms of the settlement agreement, the PFI defendants agreed to pay $550,000 “to compensate [Mr. Dern] for alleged personal injuries, costs, penalties, and all other damages and claims.” In addition, the agreement provided that it was “for and on account of [Mr. 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, Mr. Dern’s attorney sent him a check for $327,416.31, which was for the $550,000 settlement payment minus attorney’s fees and other litigation expenses. Mr. Dern and his wife (collectively, the “Derns”) filed a joint income tax return for 2017 that reported only $6,000 of nonemployee compensation (i.e., Schedule C) income pertaining to an appraisal business. That is, the Derns omitted the $327,416.31 settlement payment from PFI.
Years later, the IRS issued a notice of deficiency to the Derns for 2017 determining, on the basis of a Form 1099-MISC, that they had unreported employee compensation of approximately $327,000 (the IRS goofed on the computations). The Derns filed a petition with the Tax Court contending that the settlement payment was excludible from gross income under section 104(a)(2).
The Court’s Decision
At trial, the Derns contended that the payment should be excluded from gross income under section 104(a)(2). However, the IRS offered into evidence a copy of the settlement agreement and contended otherwise. After reviewing the settlement agreement, the Tax Court acknowledged that the agreement provided for a payment to compensate Mr. Dern “for alleged personal injuries.” However, as the reader may recall from above, section 104(a)(2) only excludes payments for “personal physical injuries or physical sickness.” Because the settlement agreement did not address whether Mr. Dern’s injuries were physical or not, the Tax Court held in favor of the IRS, particularly because the settlement agreement also contained a proviso that indicated that PFI had demanded a general release of “all claims known or unknown.”
With the settlement agreement ambiguous as to whether the payment was for “personal physical injuries or physical sickness,” the Tax Court looked at other evidence to determine whether the Derns could meet their burden of proof to show that the payment fell under section 104(a)(2). In this regard, the Tax Court noted that Mr. Dern’s complaint only alleged violations of California’s labor and antidiscrimination laws, wrongful termination, breach of contract, and intentional infliction of emotional distress. Because there was no evidence that PFI intended to compensate Mr. Dern for personal physical injuries or physical sickness, the Tax Court concluded that the IRS had correctly determined that the Derns owed approximately $100,000 in federal income taxes (plus interest).
There are several takeaways from the decision in Dern. First, to the extent a taxpayer intends to later claim on a tax return that all or a part of a settlement payment is not taxable under section 104(a)(2), the taxpayer (or his or her counsel) should ensure that the settlement agreement provides for the same. In this author’s experience, defendants will often push back on characterizing the payment as a section 104(a)(2) payment—however, this should not stop taxpayers from raising good-faith arguments otherwise. As Dern shows, taxpayers who fail to specify in the settlement agreement that all or a portion of the settlement payment is intended for personal physical injuries or physical sickness create headaches come tax return preparation time.
Second, taxpayers should be aware that in most settlement payment situations, a Form 1099 will likely be issued and provided to the IRS. That is, the IRS will be well aware that the taxpayer received a payment, and its computer system will attempt to match the information return reporting with the taxpayer’s tax return reporting. If the taxpayer fails to include the payment as gross income on the tax return, it is extremely likely that the tax return will be selected for examination. In these instances, where the taxpayer intends to raise section 104(a)(2), the IRS will ask for a copy of the settlement agreement and the complaint. Accordingly, wise counsel will address the information return reporting in the settlement agreement including who will issue the Form 1099 and for what amount.
Third, taxpayers should be aware that they can obtain tax opinions from tax professionals regarding the proper tax treatment of a payment. In many cases, the tax opinion can provide some comfort on the proper tax reporting and whether the payment at issue is taxable or not. Taxpayers who request a tax opinion often fare better against any potential IRS examination as the IRS usually views a taxpayer’s request for a tax opinion as a factor in determining whether the taxpayer was reasonable or not in taking the position on the return (which goes to the issue of whether penalties should be imposed).
For more on this topic:
- Are Lawsuits or Settlement Damages Taxable?
- A Primer on the Tax Implications of Settlements and Judgments
- The IRS’ Lawsuits, Awards, and Settlements Audit Techniques Guide
- Are Settlement Payments for Emotional Distress Taxable?
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