Tax Court Holds That Part of Taxpayer's Settlement Award Is Excludable from Income

(Parker Tax Publishing July 2020)

The Tax Court held that a taxpayer was allowed to exclude from gross income a portion of a settlement payment she received from her former employer in an employment discrimination case. The court found that although damages received in an employment discrimination case are generally not excludible from income, the settlement in this case was paid in part as damages for physical injuries the taxpayer suffered as a result of having seizures while at work and therefore was excludible under Code Sec. 104(a)(2). Beckett v. Comm'r, T.C. Summary 2020-19.

Dorothea Beckett was employed by Genesis Multi-Medical Center (Genesis) as a certified nursing assistant from 2009 until her termination in 2012. Beckett, who has epilepsy, suffered from seizures while at work. She would hit her head hard enough to require stitches or would bite her tongue and, at least once, she was sent to the emergency room. In 2014, Beckett sued Genesis for employment discrimination, claiming that she was wrongly terminated because of her epilepsy and the company's failure to make reasonable accommodation as required under the Americans with Disabilities Act.

In 2015, Beckett signed an agreement to settle the lawsuit against Genesis for $28,000. Under the settlement agreement, $1,000 was for back pay, $8,000 was for attorney's fees, which was paid directly to Beckett's attorney, and $19,000 was for claims of emotional distress, pain and suffering, and physical distress and damages. The $19,000 payment was reported on a Form 1099-MISC, Miscellaneous Income. The settlement agreement included a general release of all claims against Genesis. Beckett asked the judge presiding over her lawsuit whether the $19,000 was taxable and was told it was not because the lawsuit was based on her seizures.

On her 2015 tax return, Beckett reported the $1,000 of back pay as income but did not report the other $27,000. The IRS issued a notice of deficiency for that amount, but later conceded that the $8,000 of attorney's fees includable in Beckett's income was also deductible as an adjustment to gross income under Code Sec. 62(a)(20). The IRS said that the remaining $19,000 was taxable, and Beckett took her case to the Tax Court.

Under Code Sec. 104(a)(2), gross income does not include the amount of any damages (other than punitive damages) received by a taxpayer on account of personal physical injuries or physical sickness. In U.S. v. Burke, 504 U.S. 229 (1992), the Supreme Court held that when damages are received under a settlement agreement, the nature of the claim that was the actual basis for settlement controls whether such amounts are excludable under Code Sec. 104(a)(2). The settlement agreement is considered in the light of all the facts and circumstances, with the key factor being the payor's intent in making the settlement payment.

The Tax Court held that Beckett could not exclude the entire $19,000 from gross income under Code Sec. 104(a)(2) but that she was entitled to exclude a portion of it. The court said that while damages received as the result of a wrongful termination of employment claim are generally not received on account of personal physical injuries or physical sickness, there was a physical component to Beckett's complaint that made her case different.

The court noted that the settlement agreement explicitly stated that the compensatory damages were paid in part for physical distress and damages. In the court's view, these terms showed that Genesis intended a portion of the $19,000 to compensate Beckett for her physical injuries. The court found that this conclusion was also supported by the observation of the judge presiding over Beckett's ADA claim that her seizures were an actual basis for the settlement. The court further found that Beckett had credibly testified that she suffered head and other physical injuries directly caused by her employer's refusal to make reasonable accommodations. In the court's view, this set Beckett's case apart from the myriad of cases in which the Tax Court has held that settlement payments for wrongful termination were not excludable from income under Code Sec. 104(a)(2).

However, the court noted that the $19,000 payment was not solely for physical injuries, so the court had to decide what portion of the payment was paid on account of Beckett's personal physical injuries. The court noted that the settlement agreement identified three bases for the payment: emotional distress, pain and suffering, and physical distress and damages. The court saw no reason to doubt that this allocation was the result of adversarial, arm's length negotiations or was incongruous with the economic realities of Beckett's underlying claims. Accordingly, the court held that one third of Beckett's $19,000 settlement payment was excluded from income under Code Sec. 104(a)(2).

For a discussion of the tax treatment of damages received on account of physical injuries or 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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