Tax Court Decision Shows Potential Pitfalls when Claiming Settlements Qualify for Federal Income Tax Exclusion

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TL Fahring focuses on helping individuals and businesses with a wide variety of matters involving state, federal, and international taxation. He has represented clients in all stages of federal and state tax disputes, including audits, administrative appeals, litigation, and collection matters. Mr. Fahring also has used his tax knowledge to assist clients in planning complex domestic and international transactions, including advising as to potential reporting and withholding requirements.

Mr. Fahring received his J.D. from the University of Texas School of Law, where he graduated with high honors and was inducted into the Order of the Coif and Chancellors honors societies. After clerking for a year at the Texas Eleventh Court of Appeals, he attended New York University School of Law, where he received an LL.M. (Master of Laws) in Taxation and served as a student editor on the Tax Law Review.

A recent Tax Court case illustrates the importance under current case law of thinking about the tax consequences of a potential verdict or settlement early on and attempting (if the facts allow) to establish a basis for exclusion from federal income tax throughout the course of litigation.

In Estate of Finnegan v. Comm’r, T.C. Memo. 2024-42, the question before the Tax Court was whether payments under a settlement of certain constitutional and civil rights claims were excluded from income under section 104 of the Internal Revenue Code.

The Indiana State Police (“ISP”) had investigated husband and wife taxpayers in Estate of Finnegan for medical neglect resulting in the death of their daughter at the age of fourteen. Criminal charges were filed against husband and wife taxpayers but later were dismissed.

Nevertheless, the Indiana Department of Child Services (“DCS”) removed the remaining children from husband and wife taxpayers’ home. While the children were eventually returned home, DCS continued its investigation.

Husband and wife taxpayers filed suit in state court against DCS to invalidate certain determinations that DCS had made against them, including  (1) that there was medical neglect in connection with their deceased daughter based on the postponement of a cardiology checkup; (2 that their daughter’s death was caused by physical abuse; and (3) that their remaining children were in a life/health endangering environment. The state court found in husband and wife taxpayers’ favor.

Husband and wife taxpayers along with their children sued various employees of the State of Indiana in federal court for their actions after their daughter’s and sister’s death. The suit was brought under 42 U.S.C. § 1983 for violation of their civil rights under state law, federal law, and the First, Fourth, Sixth, and Fourteenth Amendments to the U.S. Constitution. A jury awarded the taxpayers compensatory damages totaling $31.5 million, with amounts specifically awarded for violations of each taxpayer’s constitutional rights. Ultimately, the case was settled for $25 million.

The taxpayers claimed that the $25 million settlement was excluded from gross income for purposes of calculating their federal income tax due to the post-traumatic stress disorder (“PTSD”) that the taxpayers suffered as a result of the State of Indiana’s actions. The IRS disagreed and assessed tax. The case went before the Tax Court.

Section 104(a)(2) of the Internal Revenue Code excludes from 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.”

Emotional distress is not treated as physical injury of sickness for purposes of this provision.[1] The Tax Court looked to the legislative history of section 104(a)(2), which states that “emotional distress includes symptoms (e.g., insomnia, headaches, stomach disorders) which may result from emotional distress.”[2] The Treasury Regulation clarifies that “[e]motional distress is not considered a physical injury or physical sickness” unless it is “attributable to a physical injury or physical sickness.”[3]

Damages are attributable to physical injury or physical sickness when there is the actions giving rise to the damages directly caused the physical injury or physical sickness.[4] When damages are received under a settlement agreement, the nature of the claim underlying the settlement is evaluated to determine whether the damages may be excluded under section 104(a)(2).[5] The nature of the claim is determined by first looking to the terms of the settlement and, if the terms are ambiguous, to the facts and circumstances surrounding the settlement.[6]

In this case, the Tax Court looked to the settlement agreement and pleadings to determine the nature of the claims. The Tax Court found no mention of PTSD or any physical injury or physical sickness in the settlement agreement or pleadings. Moreover, PTSD was mentioned only once in testimony. The Tax Court concluded:

With the vast ocean of evidence before us concerning the district court litigation, references to PTSD make barely a drop in the bucket. Rather, the image that overwhelmingly emerges is that the damages were paid not as compensation for PTSD but for violations of plaintiffs’ constitutional rights stemming from defendants’ conduct and the emotional pain caused therefrom.

Based on this determination, the Tax Court determined that payments under the settlement were not excluded under section 104 of the Internal Revenue Code and upheld the IRS’s assessments.


[1] I.R.C. § 104(a) (flush language).

[2] See H.R. Rep. No. 104-737, at 301 n.56 (1996) (Conf. Rep.).

[3] Treas. Reg. § 1.104-1(c)(1).

[4] Blum v. Comm’r, T.C. Memo. 2021-18, at *7–8 (citing Doyle v. Comm’r, T.C. Memo 2019-8, at *11).

[5] See United States v. Burke, 504 U.S. 229, 237 (1992).

[6] Rivera v. Baker W., Inc., 430 F.3d 1253, 1257 (9th Cir. 2005).