The taxation of legal settlements can be maddening.
The general rule is found in IRC Section 61, which can
be colloquially summarized as:
If it breathes, moves, or eats, it is taxable.
Then come the exceptions.
The Code begins with a broad rule, and
then you must find and fit into an exception to avoid taxability. A big
exception for legal settlements is Section 104(a)(2):
§ 104 Compensation for injuries or sickness.
Except in the case of amounts attributable
to (and not in excess of) deductions allowed under section 213 (relating to
medical, etc., expenses) for any prior taxable year, gross income does not
include-
(1) amounts
received under workmen's compensation acts as compensation for personal
injuries or sickness;
(2) the
amount of any damages (other than punitive damages) received (whether by suit
or agreement and whether as lump sums or as periodic payments) on account of
personal physical injuries or physical sickness;
What can we learn here?
(1) The Code does not care whether the judge decides or if the parties instead come to an agreement.
(2) It does not care if one gets paid in a lump sum or in a series of payments.
(3) It cares very much that the settlement is for something physical – whether injury or sickness.
What about something nonphysical, such as mental or
emotional distress?
Reviewing the history of the Code helps here, as we learn that the Code was changed in 1996 to clarify that mental and emotional injury settlements are excludable from income only if they arose from physical injury or sickness.
This gives the following rule of thumb:
Physical = nontaxable
Nonphysical = taxable
The attorney must be aware of the above demarcation and
wordsmith accordingly if some or all the settlement is for nonphysical
damages.
Can it be done?
Let’s look at the Montes case.
Suzanne Montes wanted to be a firefighter since she was a
little girl. She was one of the few women to pass the exam to get into the San
Francisco Fire Academy. She then was one of the few women to graduate from the program.
Good for her.
In 2016 she received a sweet assignment to a firehouse in
downtown San Francisco.
You may know that firefighters work as a team and in 24-hour shifts. There are about 10 shifts per month, so they spend a LOT of time together. Suzanne was a woman. The remainder of the team were men. Many did not welcome her. First came the disparaging comments, then sabotaging her equipment, then doing - I do not know what specifically and I do not want to know – “disgusting and extremely unsanitary” things to her personal property and effects.
Thanks, guys, for painting men as knuckle-dragging Neanderthals. Way to represent the team.
She complained.
She sued.
She won approximately $380 grand.
Good.
She went to a CPA when it was time to file. The CPA
advised that the $380 grand was not taxable.
Even better.
You know the IRS balked, as we are looking
at a Tax Court case.
The IRS’s first argument?
Start with the complaint, which claimed sex discrimination and retaliation, including the intentional infliction of emotional distress.
There are no allegations of physical disease or harm to her in the complaint.”
We are not seeing the magic words here: physical injury,
physical sickness or micrato raepy sathonich.
Hopefully her attorney salvaged this in the settlement agreement.
Here is the Court:
Our detective work here begins and ends with the settlement agreement.”
Oh oh.
There are no allegations of physical injury …, and indeed, in the summary of the complaint it says, ‘She has lost compensation for which she would have been entitled. She has suffered from emotional distress, embarrassment, and humiliation and her prospects for career advancement have been diminished.’”
No magic words.
Yep, she lost her case. The settlement was taxable.
The Court did hand her a small victory, though. Penalties did not apply because she took a reasonable position based on the advice of a CPA.
Our case this time was Montes v Commissioner, Docket No. 17332-21, June 29, 2023.
