Dern Reminds that Settlement Language is Important in Section
104(a)(2) Physical Injury Cases
Taxpayers initiate lawsuits for a variety of reasons. For
example, a taxpayer may bring a lawsuit against a defendant for
breach of contract, personal negligence, defamation, or for a
litany of other claims. Believe it or not—these
individualized claims have significance for federal income tax
As a general matter, lawsuit recoveries (whether through
judgment or settlement) are deemed fully taxable to the recipient.
Indeed, there is a presumption under well-established federal case
law that the receipt of a damage recovery is taxable. The taxpayer
must therefore rebut the presumption and demonstrate that, for one
reason or another, the recovery is not taxable.
In many of these instances, taxpayers commonly point to a
statutory exclusion from gross income under section 104(a)(2).
Under that provision, certain damages related to “personal
physical injuries or physical sickness” are excluded from
gross income—i.e., those damages are
not taxable. Because damage awards outside the
scope of section 104(a)(2) are generally taxed at ordinary income
tax rates, taxpayers who can prove that their damages fall within
the purview of section 104(a)(2) can reap significant tax
Of course, the IRS knows this as well. Accordingly, in many
cases, the IRS simply waits until after the taxpayer files
a tax return for the year in which the damages are paid and matches
the return reporting with the information return issued by the
defendant (e.g., IRS Form 1099), examining the return to
see if the payment was reported in full. If there is a mismatch in
the information return reporting and the tax return, the IRS
selects the return for examination.
When the examination occurs and the taxpayer raises section
104(a)(2), the IRS will try to determine the payor’s intent.
For federal income tax purposes, the payor’s intent is often
gleaned from the terms of a settlement agreement if one has been
entered into amongst the parties. But exactly how precise does the
language need to be to convince the IRS or the courts that the
payment falls within section 104(a)(2)? This issue is litigated
often, but the best answer is usually the clearer the better. As
shown in the recent Tax Court decision in Dern v. Comm’r, T.C. Memo. 2022-90,
taxpayers who fail to adequately specify the purpose of the
settlement payment do so at their own peril.
Facts in Dern.
Thomas Dern (Mr. Dern) worked as a sales representative for PFI,
Inc. (PFI), a manufacturer and distributor of paint and
paint-related products. In September of 2015, Mr. Dern was
hospitalized for acute gastrointestinal bleeding and a resulting
heart attack. Because Mr. Dern was hospitalized off and on for
several weeks, he was required to perform his sales duties by email
and phone in lieu of in-person sales calls.
During this period of time, an officer of PFI asked Mr. Dern to
resume making in-person sales calls. When Mr. Dern continued to
perform his sales duties by email and phone, PFI notified him that
it had terminated his sales representative agreement. PFI’s
letter in this regard stated: “[Y]our prolonged health
conditions have unfortunately had a significant impact on your
ability to effectively represent the Company and perform the duties
of a sales representative.”
After receipt of the letter, Mr. Dern hired an attorney to
represent him in a lawsuit against PFI for the following causes of
action: (1) willful misclassification in violation of California
Labor Code § 226.8; (2) disability discrimination in violation
of the California Fair Employment and Housing Act (California
FEHA); (3) failure to accommodate disability in violation of the
California FEHA; (4) failure to engage in the interactive process
in violation of the California FEHA; (5) age discrimination in
violation of the California FEHA; (6) failure to take all
reasonable steps to prevent discrimination in violation of the
California FEHA; (7) wrongful termination in violation of public
policy; (8) intentional infliction of emotional distress; (9)
failure to timely pay all wages under separation from employment;
and (10) breach of contract.
As happens in most lawsuits, the parties settled. The settlement
agreement was memorialized in a settlement agreement and mutual
release of claims. Under the terms of the settlement agreement, the
PFI defendants agreed to pay $550,000 “to compensate [Mr.
Dern] for alleged personal injuries, costs, penalties, and all
other damages and claims.” In addition, the agreement provided
that it was “for and on account of [Mr. Dern’s] claims
alleging compensatory damages, emotional injuries, penalties, and
punitive damages.” The settlement agreement also included a
general release of claims which was “intended to include in
its effect, without limitation, all claims known or unknown at the
time of the execution” of the settlement agreement.
On September 8, 2017, Mr. Dern’s attorney sent him a check
for $327,416.31, which was for the $550,000 settlement payment
minus attorney’s fees and other litigation expenses. Mr. Dern
and his wife (collectively, the “Derns”) filed a joint
income tax return for 2017 that reported only $6,000 of nonemployee
compensation (i.e., Schedule C) income pertaining to an
appraisal business. That is, the Derns omitted the $327,416.31
settlement payment from PFI.
Years later, the IRS issued a notice of deficiency to the Derns
for 2017 determining, on the basis of a Form 1099-MISC, that they
had unreported employee compensation of approximately $327,000 (the
IRS goofed on the computations). The Derns filed a petition with
the Tax Court contending that the settlement payment was excludible
from gross income under section 104(a)(2).
The Court’s Decision.
At trial, the Derns contended that the payment should be
excluded from gross income under section 104(a)(2). However, the
IRS offered into evidence a copy of the settlement agreement and
contended otherwise. After reviewing the settlement agreement, the
Tax Court acknowledged that the agreement provided for a payment to
compensate Mr. Dern “for alleged personal injuries.”
However, as the reader may recall from above, section 104(a)(2)
only excludes payments for “personal physical
injuries or physical sickness.” Because the
settlement agreement did not address whether Mr. Dern’s
injuries were physical or not, the Tax Court held in favor of the
IRS, particularly because the settlement agreement also contained a
proviso that indicated that PFI had demanded a general release of
“all claims known or unknown.”
With the settlement agreement ambiguous as to whether the
payment was for “personal physical injuries or physical
sickness,” the Tax Court looked at other evidence to determine
whether the Derns could meet their burden of proof to show that the
payment fell under section 104(a)(2). In this regard, the Tax Court
noted that Mr. Dern’s complaint only alleged violations of
California’s labor and antidiscrimination laws, wrongful
termination, breach of contract, and intentional infliction of
emotional distress. Because there was no evidence that PFI intended
to compensate Mr. Dern for personal physical injuries or physical
sickness, the Tax Court concluded that the IRS had correctly
determined that the Derns owed approximately $100,000 in federal
income taxes (plus interest).
There are several takeaways from the decision in Dern.
First, to the extent a taxpayer intends to later claim on a tax
return that all or a part of a settlement payment is not taxable
under section 104(a)(2), the taxpayer (or his or her counsel)
should ensure that the settlement agreement provides for the same.
In this author’s experience, defendants will often push back on
characterizing the payment as a section 104(a)(2)
payment—however, this should not stop taxpayers from raising
good-faith arguments otherwise. As Dern shows, taxpayers
who fail to specify in the settlement agreement that all or a
portion of the settlement payment is intended for personal physical
injuries or physical sickness create headaches come tax return
Second, taxpayers should be aware that in most settlement
payment situations, a Form 1099 will likely be issued and provided
to the IRS. That is, the IRS will be well aware that the taxpayer
received a payment, and its computer system will attempt to match
the information return reporting with the taxpayer’s tax return
reporting. If the taxpayer fails to include the payment as gross
income on the tax return, it is extremely likely that the tax
return will be selected for examination. In these instances, where
the taxpayer intends to raise section 104(a)(2), the IRS will ask
for a copy of the settlement agreement and the complaint.
Accordingly, wise counsel will address the information return
reporting in the settlement agreement including who will issue the
Form 1099 and for what amount.
Third, taxpayers should be aware that they can obtain tax
opinions from tax professionals regarding the proper tax treatment
of a payment. In many cases, the tax opinion can provide some
comfort on the proper tax reporting and whether the payment at
issue is taxable or not. Taxpayers who request a tax opinion often
fare better against any potential IRS examination as the IRS
usually views a taxpayer’s request for a tax opinion as a
factor in determining whether the taxpayer was reasonable or not in
taking the position on the return (which goes to the issue of
whether penalties should be imposed).
For more on this topic:
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The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.