Settlement Payment for Wrongful Termination Was Not Excludable from Income

(Parker Tax Publishing January 2024)

The Tax Court held that a $75,000 payment a taxpayer received to settle her claims against her former employer was not excludable as a payment on account of personal physical injury or physical illness under Code Sec. 104(a)(2), even though the settlement agreement stated that the payment was in part for the taxpayer's "purported personal injury." The court found that nothing in the agreement stated that the payment was for physical injuries and that the surrounding facts and circumstances showed the payment was compensation for wrongful termination. Quevy v. Comm'r, T.C. Summary 2023-34.

Background

Kristen Quevy began working for Acuity Brand Lighting (Acuity) in 2009. At the time of her departure in 2017, she worked as a Lead Design Engineer in the Hydrel Division.

Quevy suffers from anxiety, which conflicted with her work at Acuity. The work conditions exacerbated her anxiety, which led to migraines and agoraphobia. And during her time at Acuity, Quevy informed her employer that she was assaulted, which worsened her anxiety. When Quevy's increased anxiety began to interfere with her work, Acuity permitted her to work from home. But by 2016 Quevy's supervisor asked her to return to work in person. Quevy told Acuity that she was not able to do so, and the company asked her to go on unpaid medical leave, which she did. While on leave she received short-term and long-term disability benefits. The experience of going on unpaid medical leave further worsened Quevy's anxiety.

Quevy's medical troubles worsened. Her anxiety, agoraphobia, and migraines led to alcoholism. She had planned to enter a residential treatment facility for an extended period to address her alcoholism, but before she could begin treatment, she discovered she was suffering from breast cancer. After undergoing treatment for breast cancer, Quevy entered residential treatment for alcoholism. When she left the facility, a care team consisting of a psychologist, a psychiatrist, and a general practitioner continued to look after her. These medical troubles resulted in her deducting over $125,000 of medical expenses for 2016 and 2017, combined.

A dispute arose with respect to Quevy's disability benefits. In response to a questionnaire from Quevy's disability benefits provider, all three members of her care team reported that the earliest she could return to work was November 2017. But on June 2, 2017, the disability benefits provider informed Quevy that she no longer qualified as disabled for the purpose of receiving benefits. The decision had the effect of terminating her disability benefits and clawing back contributions to her health insurance as of May 10, 2017. Quevy called Acuity's employee service center to discuss her medical benefits and discovered that her health insurance had converted to COBRA coverage and that she was responsible for all costs.

Quevy suffered a relapse with alcoholism and voluntarily admitted herself to a mental health facility. Soon after leaving the mental health facility in the summer of 2017, she was involved in a car accident that injured her spine.

After Quevy's disability benefits were terminated, Acuity's Human Resource department contacted her to discuss when she planned on returning to work. Quevy explained she would not be able to return until November of 2017. Acuity subsequently terminated Quevy's employment.

Quevy sought compensation from Acuity. The company initially offered to pay Quevy back wages, which she rejected. Quevy retained an attorney who sent two demand letters to Acuity on her behalf. The first letter set forth Quevy's potential claims "of discrimination and retaliation on the basis of her disabilities and requests for reasonable accommodation and wrongful termination." The second letter further elaborated on Quevy's claims of discrimination and wrongful termination. The demand letters expressed her intent to sue for damages for wrongful termination on account of Acuity's failure to accommodate her disabilities.

Acuity ultimately agreed to pay $75,000 pursuant to a settlement agreement. The settlement agreement characterized the $75,000 as being paid as "severance compensation" to Quevy to "resolve all issues between them, including but not limited to Employee's employment and the termination of that employment." The settlement agreement stated that the payment was for Quevy's "alleged damages, which includes alleged injuries incident to her employment with Employer, including those related to her purported personal injury and employment." Although there is a reference to a "purported personal injury," neither the settlement agreement nor the demand letters refer to any physical injury.

Acuity paid Quevy $75,000 in early 2018 and reported the payment on a Form 1099-MISC, Miscellaneous Income, as nonemployee compensation. Quevy included $7,500 of the settlement payment in gross income for 2018 but excluded the rest. She excluded it under the belief that it was excludable under Code Sec. 104(a)(2) as damages received on account of personal physical injury or physical sickness. The IRS sent Quevy a notice of deficiency, increasing her taxable income to include the remaining $67,500 of the settlement payment.

Quevy took her case to the Tax Court. Quevy argued that she was entitled to exclude from her gross income some or all of the settlement payment she received under Code Sec. 104(a)(2) as damages on account of personal physical injuries or physical sickness. Alternatively, she argued that the settlement payment was excludable as compensation for amounts paid for medical care attributable to emotional distress. The IRS contended that the settlement payment was compensation for wrongful termination, which is not excludable under Code Sec. 104(a)(2). The IRS further argued that, for Quevy to exclude the payment as compensation for medical expenses, she had to show she did not previously claim those expenses as an income tax deduction, or if she did, that she did not receive a tax benefit from that deduction.

Analysis

The Tax Court entered a decision for the IRS after finding that Quevy failed to establish that she received the settlement payment on account of personal physical injury or physical illness. Further, to the extent Quevy argued the payment was excludable as compensation for medical expenses, the court found that Quevy failed to establish that she had not previously received a tax benefit from deducting those expenses.

The court observed that under the terms of the settlement agreement, Acuity compensated Quevy for a broad release of claims, both known and unknown. Although the agreement mentioned "personal injuries," the court found noted that in the agreement indicating that it was for physical injuries. While Quevy contended that Acuity knew she suffered an assault in the workplace, the court found that the record did not support her reading of the agreement.

Looking beyond the settlement agreement, the court found that the surrounding facts and circumstances showed that Acuity compensated Quevy for wrongful termination and not personal physical injuries. The court found that Quevy's attorney sent Acuity two separate demand letters, both of which focused exclusively on "discrimination and retaliation on the basis of her disabilities" and "wrongful termination." The demand letters made clear, in the court's view, that the settlement agreement was to resolve Quevy's claims of discrimination and wrongful termination, not to seek compensation for a personal physical injury or physical illness. The court concluded that, because Quevy did not receive these damages on account of personal physical injuries or physical sickness, she had to include them in gross income.

The court also determined that Quevy was not entitled to exclude the damages received under the theory that they were to compensate her for medical expenses incurred to treat her emotional distress. Neither the agreement nor the demand letters, the court found, referred to compensation for medical expenses. Even assuming the settlement payment was intended to compensate Quevy for medical expenses incurred to treat her emotional distress, the court found that Quevy did not establish an amount, if any, of medical expenses incurred that she had not already deducted. Thus, even if the settlement payment could be excluded because it was intended to compensate Quevy for her medical expenses, the court concluded that Quevy failed to show she did not receive a tax benefit from previously deducting those medical expenses.

For a discussion of the exclusion for 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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