Settlement for Disability Benefits Not Excludable as Damages for Sickness

(Parker Tax Publishing September 2016)

The Tax Court held that a taxpayer's settlement for unpaid disability benefits was not excludable from his gross income. The court found the taxpayer could not prove the settlement proceeds were excludable under Code Sec. 105(c) as payments for the permanent loss of a body function. In addition, the court determined that because the nature of the suit was to recover benefits, not for physical injuries or physical sickness, the proceeds weren't excludable under Code Sec. 104(a)(2). Braddock v. Comm'r, T.C. Summary 2016-46.

Background

Prior to 2009, Richard Braddock was employed by Endress & Hauser (E&H), a company producing a range of instruments designed for use in dangerous environments and extreme conditions. During Braddock's employment with E&H, he was diagnosed with, among other things, a progressive musculoskeletal and neuromuscular syndrome, including progressive musculoskeletal pain. The pain was based on a combination of severe degenerative arthritis and neuromuscular disease. Braddock was provided with long-term disability coverage through the Lincoln National Life Insurance Co. (Lincoln National).

In 2009, Braddock left E&H and filed a claim for long-term disability benefits with Lincoln National, which subsequently denied his claim. In October 2010, Braddock filed a complaint against Lincoln National in a state district court, seeking long-term disability benefits under an ERISA plan pursuant to 29 U.S.C. Sec. 1132(a)(1)(B). In the complaint, the only mention of Braddock's condition was that he became disabled because of "certain problems from which he suffered," alleging that he was "forced to cease working and file a claim for long-term disability benefits."

In January 2011, Braddock signed a settlement agreement under which he accepted $45,000 as a settlement payment in consideration for settling his case and releasing Lincoln National generally. The agreement did not reference Braddock's health problems.

Although Braddock received a 2011 Form W-2 reporting the $45,000 as wage income, he did not report the $45,000 on his 2011 tax return. Following an audit, the IRS increased in Braddock's wage income by $45,000.

Analysis

Under Code Sec. 105(a), amounts received by an employee through accident or health insurance for personal injuries or sickness must be included in gross income to the extent those amounts:

(1) are attributable to contributions by the employer that were not includible in the gross income of the employee; or

(2) are paid by the employer.

Payments that are includable in income under Code Sec. 105(a) may nevertheless be excludable from income under Code Sec. 105(c) if they meet one of two requirements:

(1) the payments are for the permanent loss of a member or function of the body, or the permanent disfigurement of the taxpayer; or

(2) the payments are computed with reference to the nature of the injury and without regard to the period the employee is absent from work.

Code Sec. 104(a)(2) allows taxpayers to exclude from income the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or periodic payments) on account of personal physical injuries of physical sickness.

Before the Tax Court, Braddock argued that the settlement payment of $45,000 was excludable from his gross income under Code Sec. 105(c) or, in the alternative, was excludable under Code Sec. 104(a)(2).

The court noted that the parties did not address who paid the contributions to the disability insurance plan. In order for settlement proceeds to be excludible from income under Code Sec. 105(c), the requirements of Code Sec. 105(a) must first be met. Since Braddock had not proven that his employer paid the disability insurance premiums, he did not meet his burden of proof as to the requirements of Code Sec. 105(a). However, although Braddock did not meet his burden of proof and the court thus did not need to consider whether the settlement payment was excludable under Code Sec. 105(c), the court said that it would address Braddock's assertions since he had premised much of his case on an exclusion under that section.

The court stated that it has long held that insurance payments excludible from gross income under Code Sec. 105(c)(1) must fall into one of three categories: (1) payments for the permanent loss or loss of use of a member of the body; (2) payments for the permanent loss or loss of use of a function of the body; or (3) payments for permanent disfigurement. The court noted it has held that a loss of a function exists if it leaves a taxpayer "effectively without the use of his hands, legs, and feet, as opposed to whether his use is partially impaired." The court found that while Braddock claimed that his injuries "include paralysis, chronic cramping, and chronic pain," he did not provide proof of those assertions or that the settlement payment was for the permanent loss of his arms, legs, or feet or a function of such. Therefore, the court concluded that Braddock could not prove that the settlement payment is excluded from income under Code Sec. 105(c).

With regard to exclusion under Code Sec. 104(a)(2), the court noted that when a taxpayer receives a payment under a settlement agreement, as in the instant case, the nature of the claim that was the actual basis for settlement guides whether the payment is excludable from income. In this case, Braddock needed to show that his settlement payment was in lieu of damages for physical injuries or physical sickness. Braddock's action against Lincoln National, the court observed, was based on the cause of action under 29 U.S.C. Sec. 1132(a)(1)(B). Essentially, the court said, this section allows a person who participates in or benefits from a plan (including disability insurance) that is subject to ERISA to bring a civil action to enforce the participant's or beneficiary's rights under the plan. In filing that complaint, the court stated, Braddock was seeking to recover benefits he claimed Lincoln National owed him under the long-term disability insurance plan. The court noted the complaint expressly stated that Braddock sought long-term disability benefits and made only passing reference to "certain problems from which he suffered." It did not identify Braddock's physical injuries or physical sickness. Because the damages Braddock received were for nonpayment of disability insurance payments, the court found the lawsuit was not in the nature of a claim for recovery for physical injuries or physical sickness and thus the settlement proceeds were not excludable under Code Sec. 104(a)(2).

For a discussion of the exclusion from income of settlement proceeds relating to physical injuries or sickness, see Parker Tax ¶75,910.

For a discussion of amounts received through accident or health insurance, see Parker Tax ¶75,915.

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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