Your clients’ elation over receiving healthy settlement amounts for their claims can quickly turn sour when they realize the tax implications. Two rulings from the U.S. Tax Court — one involving an employment case and the other involving legal malpractice — serve as valuable reminders that “gross income” is defined broadly. But statutory exclusions, including those for damages, are narrowly construed.

Stassi Case

In the employment case, the plaintiff was diagnosed with shingles in February 2014 and had symptoms during her tenure with her employer. On May 21, 2014, she was placed on a 30-day improvement plan. From the next day until her resignation, she was on unpaid leave.

On May 27, 2014, the plaintiff sent a letter to one of her employer’s board members, complaining about the work environment. The letter made no reference to physical injury or sickness.

In December 2014, her attorney sent the employer a document demanding wages for wage and hour violations, constructive termination, and “emotional distress and punitives.” A few months later, the parties settled for $80,000. The settlement agreement referenced, among other things, physical manifestations of emotional distress, although the plaintiff’s initial complaint hadn’t.

About $10,000 of the settlement amount was designated consideration for lost wages, with the remainder designated as consideration for physical manifestations of emotional distress. The employer issued a Form W-2 and a Form 1099-MISC accordingly. The plaintiff reported the wage consideration as taxable wages but reported only $1 of the balance as “other income.” The IRS determined an income tax deficiency of about $16,000, and the plaintiff appealed.

The court explained that, under IRC Section 104(a)(2), nonpunitive damages received on account of physical injuries or sickness generally aren’t considered gross income for tax purposes. Emotional distress isn’t treated as a physical injury or illness, however. The critical question, therefore, is “in lieu of what were the damages awarded?”

The plaintiff contended that the agreement’s inclusion of the words “physical manifestations” established the payments were for physical injury or sickness. But the court found she provided no evidence that showed her shingles were related to or caused by her employment. Because she didn’t file a complaint based on physical injury or sickness, and the agreement didn’t state that the payment was in lieu of damages for such, no part of the settlement was excludable.

Blum Case

Ten days after releasing the Stassi decision, the Tax Court issued another opinion dealing with the taxability of settlement proceeds. This case arose out of a medical malpractice claim, where the plaintiff alleged that she suffered injuries after falling from a broken wheelchair that a hospital admissions clerk had directed her to sit in.

The plaintiff lost her medical malpractice case and subsequently brought a malpractice case against her former attorneys. She claimed they breached their duty of care in failing to properly prosecute her lawsuit against the hospital. Her complaint didn’t allege any physical injuries attributable to the attorneys or seek compensation for any physical injuries.

The parties settled for $125,000, which the plaintiff didn’t report to the IRS. She was assessed a deficiency of $27,418 and turned to the Tax Court for relief. The plaintiff asserted that the payment was excludable because, “but for” the attorneys’ allegedly negligent representation, she would have received damages that were excludable.

The court countered that a taxpayer must show a direct causal link between the damages and personal injuries. The settlement agreement, however, made clear that the payment wasn’t directly linked to the injuries and that she was being compensated for legal malpractice. For example, it stated that her “physical injuries are … alleged to have resulted from the … [hospital] incident, which did not occur as a result of any fault or negligence by” the attorneys. Thus, the payment wasn’t excludable from income.

Leave No Doubt 

Your clients’ misunderstanding of the proper tax treatment of their settlement proceeds can land them in hot water with the IRS. Make sure they’re clear on the law from the outset and that the final settlement language unambiguously reflects the parties’ intent regarding the compensation.



TheKFORDgroup litigation team holds extensive knowledge and experience in expert witness engagements, forensic accounting, and business valuations.  Our experts are trained and experienced in the litigation process.  We have the extensive experience in taxes and litigation cases.   We can assist you or your client in determining the tax consequences from their potential settlement.    For more information, please call us at 210-340-8351.

Additional information included in this report was provided by PDI Global / Thomson Reuters © 2021

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