by John Darer CLU ChFC MSSC RSP CLTC
The United States Tax Court recently concluded in T.C. Memo 2017-191 that the settlement proceeds compensated a plaintiff for damages she suffered on account of disability-based discrimination, reprisal for engaging in protected Equal Employment Opportunity (EEOC) activity, and an improper medical inquiry; no portion of the settlement proceeds represented damages on account of personal injury or physical sickness. The Court held that petitioners may not exclude any portion of the settlement proceeds from gross income.
LAURA STEPP AND KALEB STEPP, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent No. 13384-14 UNITED STATES TAX COURT filed September 27, 2017
Laura Stepp worked for the Transportation Safety Administration (TSA) and reached a monetary settlement with TSA. The settlement agreement stated that she would withdraw with prejudice her EEOC complaint that was the subject of the EEOC decision as well as any other pending informal or formal complaints filed with the TSA and allegations of hostile work environment, harassment, retaliatory harassment, gender and disability discrimination, and retaliation. In return, TSA would (among other things) pay Mrs. Stepp a lump sum of $121,500. The agreement recited her understanding that she bore sole responsibility for compliance with all federal, state and local tax requirements and any federal or state income taxes she may owe as the result of her receipt of the lump sum settlement amount.
Misstep by Stepp
Before preparing their tax return, the Stepps received a Form 1099-MISC Miscellaneous Income, from the U.S. Department of Homeland Security, reporting a $121,500 payment from the settlement of the lawsuit. The Stepps reported the settlement income on their return but deducted $55,000 as DIRECT PAYMENT TO OTHERS and $66,500 as PERSONAL INJURY REIMBURSEMENT, effectively attempting to exclude all the settlement proceeds from their gross income. After a document-matching examination revealed this discrepancy, the IRS issued petitioners a timely notice of deficiency for 2011, determining that the $121,500 payment should have been included in gross income. Petitioners timely petitioned the Court, contending that the $121,500 payment was excludable from gross income under section 104(a)(2).
IRC 104(a)(2) What Did Congress Intend?
Congress intended the IRC 104(a)(2) exclusion to cover damages that flow from a physical injury or physical sickness. See H.R. Conf. Rept. No. 104-737, at 301 (1996), 1996-3 C.B. 741, 1041. For this purpose, emotional distress shall not be treated as a physical injury or physical sickness, sec. 104(a) (penultimate sentence), nor shall mental anguish, humiliation and embarrassment, Shaltz v. Commissioner, T.C. Memo. 2003-173.
The Court further cited United States v. Burke, 504 U.S. 229, 237 (1992). When damages are received under a settlement agreement, the nature of the claim (sometimes referred to as origin of the claim) that was the actual basis for the settlement determines whether the damages are excludable under section 104(a)(2).
Documentation Documentation Documentation!
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The settlement agreement executed by the parties in August 2011 stated quite clearly what claims the payment was made to settle namely, the claims of discrimination, harassment, retaliation, and hostile work environment that were the subject of the EEOC litigation. Looking more broadly at the dominant intent of the payor, the Court finds it clear from the record that TSAs dominant reason behind this agreement was to settle the EEOC litigation. The settlement documents do not refer to physical injury of any kind.
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