Tax Court in Brief | Dern v. Comm’r | Direct Causation a Must to Exclude from Income Damages for Injury or Sickness, Section 104(a)(2)

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The Tax Court in Brief – August 29th – September 2nd, 2022

Freeman Law’s “The Tax Court in Brief” covers every substantive Tax Court opinion, providing a weekly brief of its decisions in clear, concise prose.

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Tax Litigation:  The Week of August 29th, 2022, through September 2nd, 2022

Dern v. Comm’r, T.C. Memo. 2022-90| August 30, 2022 | Vasquez, J. | Dkt. No. 7595-20

Short Summary:

In this memorandum opinion, the Tax Court set forth its ruling based on its view of the relevant facts and points of law after holding a remote trial. The Petitioner, Thomas Dern, received a settlement in connection with a suit against his former employer. He did not report the amount he received as income or pay taxes on the amount. The IRS determined a deficiency of just under $100,000.00. Mr. Dern was a commissions-based sales representative who worked for a single manufacturer as an independent contractor. As a result of serious acute gastrointestinal bleeding and a resulting heart attack in September 2017, Mr. Dern missed a few months of work, then resumed duties working only from home in December and January. The employer asked him to resume in-person sales calls in January. He continued working only remotely. The employer then terminated Dern’s sales representative agreement at the end of the month.

Dern then sued the company under California law for misclassification of employment status, wrongful termination, failure to pay wages, breach of contract, intentional infliction of emotional distress, failure to take all reasonable steps to prevent discrimination, and for several violations of the California Fair Employment and Housing Act. Those violations included disability discrimination, failure to accommodate disability, age discrimination and failure to engage in the interactive process required by that Act. Eventually, the parties entered a written settlement agreement. The employer agreed “to compensate [Mr. Dern] for alleged personal injuries, costs, penalties, and all other damages and claims.” In addition to a general release, the agreement contained a statement that the payment was “for and on account of [Mr. Dern’s] claims alleging compensatory damages, emotional injuries, penalties, and punitive damages.”

Key Issue:

Dern argued that the illness led to his firing and that, consequently, the settlement payment qualified as non-taxable income. The Court analyzed whether Dern’s settlement payment qualified for the exclusion from gross income established in IRC section 104(a)(2) for “damages (other than punitive damages) received […] on account of personal physical injuries or physical sickness.”

Primary Holding:

The entire amount Dern received was taxable income as it was not compensation for physical sickness or injury. In the lawsuit, Dern never asserted he became ill as a result of his work. In fact, he admitted the illness was unrelated. Accordingly, the employer did not compensate Dern for any sickness or injury. Because there was not a direct causal link between the payment and the physical injury, the payment did not qualify for the section 104(a)(2) exclusion.

Key Points of Law: