A Firefighter Sues

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.

(a)  In general.

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.

 

Tattletaling on Sales Taxes

There is a tax case coming before the Supreme Court. It involves Wayfair, the online home goods company, and sales taxes.

The issue can be summarized as follows: if I do not have a building or inventory or employees in your state, can you force me to collect your taxes?

The Wayfair case is an evolution of the Quill case, decided by the Supreme Court in 1992. Quill is an office-supply company, and in 1992 the issue was whether North Dakota could tax Quill just because it sent catalogues to residents of the state.

North Dakota was adamant: Quill was regularly and systematically soliciting its citizenry. It did not care that Quill had no presence in the state. By that reasoning Norway could have also taxed Quill, but let’s not introduce common sense into this argument.

The Supreme Court was unwilling to go that far, recognizing that sales taxation was (and is) the wild west of taxation. Each state has its own rules and - depending upon the state - there can also be counties and cities imposing sales tax.  

What has changed since Quill? The internet, of course.

The new argument is that the internet has revolutionized how business is done.

But sales taxes are still eccentric, often cryptic and frustratingly inconsistent. The internet has not revolutionized that. Perhaps Amazon can wield the accounting staff necessary to comply, but a small business may have a different result.

I have a client that got mugged by the “tattletale” statutes that some states are now implementing.

Let’s look at Washington’s tattletale law.

It applies if you do not otherwise collect Washington sales tax.  

Let’s say that you sell promotional materials for old-time movies. You have a modest warehouse in a nondescript part of town, You sell exclusively over the internet, and you get paid almost exclusively through PayPal.

You have a sale in Washington state. Then two, four, ten…. You get the idea.

Washington is watching you.

Get to $10,000 in Washington sales and you have issues.

Oh, they cannot force you to collect sales taxes, but they can force you to:

(1) Conspicuously post on your website that sales taxes are due and that the purchaser must file a use tax return.

Fail to do so and there is an immediate penalty of $20,000.

Ouch.

Are we done?

Of course not.

Let’s say that you actually sell something.

(2) You must provide a notice with every sale that no sales tax is being collected, that the purchaser should file a use tax, and instructions on how to pay the use tax. The notice must be “prominently” displayed.

You write a standard notice and keep copies.

Are we done?

(3) At year end you must send the purchaser a list of everything they bought, by date. You again must provide the usual gospel on use tax and how to get information on its filing.

This starting to get expensive. Who has time for this nonsense?

Make time. The penalties begin at $5,000 and can increase exponentially.

(4) You must send a copy of that list to the state of Washington.

Fail to do so and penalties begin at $20,000.

By my math, if you sell $10,001 into Washington and do not become an unpaid agent of the Department of Revenue, you are exposed to $45,000 in penalties.

Washington of course says that it can waive penalties.

Fairy tales used to be for children. 

And the fairy tale is a one-off only. There is no second chance at a waiver.

Mind you, Washington’s state sales tax rate is 6.5%. Go to Seattle and you pick up a city sales tax, making the combined rate 9.6%

What pathological bureaucrat sets the bar at $650 in sales tax?

This is the standard structure of the tattletale laws: resistance is futile.

In ancient times – say the 1980s – there was a concept in state taxation called the Commerce Clause. This refers to the Constitution and its restriction on states to not so burden and fetter their laws so as to interfere with interstate commerce.

Seems to me that the Supreme Court should consider the Commerce Clause implications of a $45,000 penalty on $10,001 in sales when considering the Wayfair decision.

I know.

Fairy tales used to be for children.

The Foreign Income Exclusion When You Leave Mid-Year

We have a client who worked as a contractor in Afghanistan last year.

Let’s talk foreign income exclusion.

There are ropes.

The first is simple: to get to that exclusion you (a) must be a bona fide resident of a foreign country or (b) you have to be outside the United States for a certain number of days.

The bona fide exception is few and far between, and I doubt Afghanistan-as-a-destination would ever enter the conversation. In my experience, bona fide means a military, military-contractor or foreign service person (or family) who went overseas and did not return. There are only so many of those folks.

Nope, you and I (likely) have to meet a second test: the “physical presence” test. You and I have to be outside the United States for at least 330 days in a 365-day stretch.

A few things about this:

(1) 365 days does not necessarily mean a calendar year. It just needs to be 365 successive days. It does not have to end on December 31 or start on January 1.

(2) Let’s say that you are overseas for years. You can reset that 365-day period every year, as long as you can get to 330 days each time you reset.

(3) It does not mean that you have to be in the same country for 330 days. It just means that you have to be outside the United States. You can travel like a fiend – as long as you do not come back to the U.S.

(4) This is an all-or-nothing test. Botch the 330 days and you get nothing. There is no participation trophy here.

The maximum 2016 foreign income exclusion is $100,800.

Wait! There is a second calculation.

You have to prorate $100,800 by the number of days you were outside the U.S.

Huh?

Leave the U.S. late in the year – say August – and most of the exclusion disappears. Why? An August departure means the most you can claim is 5/12 of the maximum exclusion.

This second calculation very much means a calendar year.

And there you have the reason for much confusion in this area: there are two 12-month tests. The first one does not care whether your 12 months line-up with the calendar. The second one definitely means a calendar year.

Let’s recap:

(1) Take a 365-day period. It does not have to start on January 1; you can start it whenever you want.

a.    You need 330 days.

b.    Implicit in that statement is that some of those 330 days may have occurred in the calendar year before or following. It doesn’t matter. The 365 does not need to be in the same calendar year.

c.     Fail this test and you are done.

d.    Pass this test and you have a shot at winning the $100,800 prize.

(2) Next calculate how many days you were outside the U.S. in 2016. Divide that number by 365, giving you a ratio. We will call the ratio Mortimer.

a.    Multiply Mortimer by $100,800.

b.    The result is your maximum 2016 foreign income exclusion.

The first year can be a tax surprise for an American working overseas. It was for our client.

Why?

He was counting on the full $100,800.

What went wrong?

He did not leave the United States until April.

He was not happy.