Exclusion for Physical Injuries or Sickness

Physical Sickness Not Sufficient to Exclude Settlement Payment

Settlement payments paid to compensate a taxpayer for his physical sickness or injury are not taxable. This rule has been heavily litigated. It often comes down to what proof there is of the physical sickness or injury. In George v. Commissioner, T.C. Memo. 2016-156, the court addressed an argument that the physical sickness or injury could be inferred given that there was no economic damages.

The facts and procedural history are as follows:

  • The taxpayer was a car salesman in New York.
  • He found a new job and brought suit against his former employer and two former co-workers for discrimination under the Civil Rights Act of 1964 and comparable provisions of the New York Human Rights Law.
  • He alleged that he was “constructively discharged” from Dana by virtue of a hostile work environment caused by the alleged discrimination.
  • The parties reached a settlement whereby the taxpayer released all claims in exchange for a $45,000 payment.
  • The taxpayer paid $15,000 to his attorney.
  • The taxpayer did not report the $45,000 as income on his personal income tax returns.
  • The former employer issued a Form 1099-MISC to the taxpayer, which was no doubt picked up by the IRS computer matching system and which likely generated an adjustment notice and eventually the court case.

The Exclusion for Physical Injuries or Sickness

The taxpayer’s position was that the $45,000 settlement payment was excluded from gross income under Section 104(a)(2), as damages received “on account of personal physical injuries or physical sickness.” This rule generates considerable amount of controversy between the IRS and taxpayers. The question in many cases involving this rule is whether there was a physical injury or physical sickness or merely emotional distress. Emotional distress is not sufficient to exclude the settlement payment.

The courts often look to the origin of the claim to determine whether there was a physical injury or physical sickness or merely emotional distress. This often involves evaluating the complaint or petition the taxpayer filed in the underlying lawsuit. Absent any indication of whether the claim was for a physical injury or sickness, the courts also consider the settlement agreement terms. Absent this type of evidence, the courts may also consider other evidence that shows that the payor intended to compensate the taxpayer for physical injuries or sickness.

The Lack of Evidence Establishing Physical Injuries or Sickness

In this case, the taxpayer’s original complaint included a general allegation of “psychological and physical harms,” but it did not allege with any specificity that the taxpayer had suffered actual physical injury or physical sickness. Moreover, the settlement agreement also did not reference any physical injuries or sickness. It does not appear that the taxpayer presented evidence that he sought treatment from a licensed professional or other evidence of a physical injury or sickness.

The Lack of Economic Harm is Not Sufficient

The taxpayer argued that he must have been compensated for a physical injury or sickness as he was not compensated for an economic harm. The taxpayer based this argument on the fact that he earned more money from his new job than he did at his prior job. So the taxpayer argued that the court could infer that the payment was for physical injury or sickness because it was not for economic harm.

The court did not agree that this had a bearing on the intent of the payor. It concluded that it showed that the payor compensated the taxpayer for discrimination and not a physical injury or sickness. So the court reasoned that it was not limited to just physical injury or sickness or economic harm. Discrimination was a third option–and one that the court found to be the most appropriate option given the facts.

How to Deduct Attorney’s Fees

The court also addressed whether the $15,000 attorney’s fees were deductible above or below the line. This issue has also generated quite a bit of controversy between the IRS and taxpayers.
Attorney’s fees deducted above the line are not subject to phase outs or otherwise limited, as in the case of Schedule A itemized deductions.

The IRS argued that the attorney’s fees in this case were Schedule A itemized deductions.
The court did not agree with the IRS. It concluded that the attorney’s fees were above-the-line deductions pursuant to Section 62(a)(20). This section provides that payments for discrimination under the Civil Rights Act of 1964 are above-the-line deductions. As noted by the court, the settlement agreement here specifically stated that it applied to claims for compensation “with respect to the employment relationship and termination thereof.” Given this language, the court concluded that the taxpayer paid legal fees to secure a settlement of his claim for unlawful employment discrimination and that Section 62(a)(20) entitled him to an above-the-line deduction of $15,000 for his legal fees.

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