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Tax Court In Brief | Dern v. Comm’r | Direct Causation A Must To Exclude From Income Damages For Injury Or Sickness, Section 104(a)(2) – Income Tax



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The Tax Court in Brief – August 29th – September
2nd, 2022

Freeman Law‘s “The Tax Court in Brief” covers every
substantive Tax Court opinion, providing a weekly brief of its
decisions in clear, concise prose.

For a link to our podcast covering the Tax Court in Brief,
download here or check out other episodes of
The Freeman Law Project.

Tax Litigation: The Week of August 29th, 2022, through
September 2nd, 2022

Dern v. Comm’r, T.C. Memo. 2022-90| August 30, 2022
| Vasquez, J. | Dkt. No. 7595-20

Short Summary:

In this memorandum opinion, the Tax Court set forth its ruling
based on its view of the relevant facts and points of law after
holding a remote trial. The Petitioner, Thomas Dern, received a
settlement in connection with a suit against his former employer.
He did not report the amount he received as income or pay taxes on
the amount. The IRS determined a deficiency of just under
$100,000.00. Mr. Dern was a commissions-based sales representative
who worked for a single manufacturer as an independent contractor.
As a result of serious acute gastrointestinal bleeding and a
resulting heart attack in September 2017, Mr. Dern missed a few
months of work, then resumed duties working only from home in
December and January. The employer asked him to resume in-person
sales calls in January. He continued working only remotely. The
employer then terminated Dern’s sales representative agreement
at the end of the month.

Dern then sued the company under California law for
misclassification of employment status, wrongful termination,
failure to pay wages, breach of contract, intentional infliction of
emotional distress, failure to take all reasonable steps to prevent
discrimination, and for several violations of the California Fair
Employment and Housing Act. Those violations included disability
discrimination, failure to accommodate disability, age
discrimination and failure to engage in the interactive process
required by that Act. Eventually, the parties entered a written
settlement agreement. The employer agreed “to compensate [Mr.
Dern] for alleged personal injuries, costs, penalties, and all
other damages and claims.” In addition to a general release,
the agreement contained a statement that the payment was “for
and on account of [Mr. Dern’s] claims alleging compensatory
damages, emotional injuries, penalties, and punitive
damages.”

Key Issue:

Dern argued that the illness led to his firing and that,
consequently, the settlement payment qualified as non-taxable
income. The Court analyzed whether Dern’s settlement payment
qualified for the exclusion from gross income established in IRC
section 104(a)(2) for “damages (other than punitive damages)
received […] on account of personal physical injuries or physical
sickness.”

Primary Holding:

The entire amount Dern received was taxable income as it was not
compensation for physical sickness or injury. In the lawsuit, Dern
never asserted he became ill as a result of his work. In fact, he
admitted the illness was unrelated. Accordingly, the employer did
not compensate Dern for any sickness or injury. Because there was
not a direct causal link between the payment and the physical
injury, the payment did not qualify for the section 104(a)(2)
exclusion.

Key Points of Law:

  • Determinations in a notice of deficiency are generally presumed
    correct, and the taxpayer bears the burden of proving them
    erroneous. Welch v. Helvering, 290 U.S. 111, 115 (1933);
    Merkel v. Commissioner, 192 F.3d 844, 852 (9th Cir. 1999),
    aff’g 109 T.C. 463 (1997).

  • In the 9th Circuit, in a case for failure to report income the
    Commissioner must first establish “some evidentiary
    foundation” linking the taxpayer to an alleged
    income-producing activity before an IRS determination is presumed
    correct. Weimerskirch v. Commissioner, 596 F.2d 358,
    361–62 (9th Cir. 1979), rev’g 67 T.C. 672 (1977). After
    the foundation is established, the taxpayer has the burden of
    proving the determination is arbitrary or erroneous. See Hardy
    v. Commissioner
    , 181 F.3d 1002, 1004–05 (9th Cir. 1999),
    aff’g T.C. Memo. 1997-97.

  • Gross income includes all income from any source and statutory
    exclusions from gross income are narrowly construed; petitioners
    have the burden to clearly establish the application of any alleged
    exclusion. See Commissioner v. Schleier, 515 U.S. 323,
    328, 336-37 (1995); United States v. Burke, 504 U.S. 229,
    233-234 (1992).

  • Without a written statement specifying what type of legal harm
    the settlement proceeds were intended to compensate, the Tax Court
    determines the intent of the payor based on the facts and
    circumstances of this case. See Knuckles v. Commissioner,
    349 F.2d 610, 613 (10th Cir. 1965), aff’g T.C. Memo.
    1964-33.

  • To qualify for the section 104(a)(2) exclusion, there must be a
    “direct causal link” between the payment and the physical
    injury or illness. See Lindsey v. Commissioner, 422 F.3d
    at 688. (8th Cir. 2005), aff’g T.C. Memo.
    2004-113.

  • Because the Tax Court is not a court of equity, it cannot
    ignore the law to achieve an equitable result. See Commissioner
    v. McCoy
    , 484 U.S. 3, 7 (1987); Stovall v.
    Commissioner
    , 101 T.C. 140, 149–50 (1993); Paxman v.
    Commissioner
    , 50 T.C. 567, 576–77 (1968), aff’d, 414
    F.2d 265 (10th Cir. 1969).

Insights:

  • When settling cases involving employment disputes, especially
    when they involve misclassified employees, employers, employees and
    their counsel should pay close attention to the tax consequences
    that attach to settlement payments.

  • The IRS originally asserted that Dern failed to pay
    self-employment tax. But prior to trial, the Commissioner conceded
    this point. This was likely a result of Dern’s
    misclassification as an independent contractor. Presumably, the
    payment included amounts deemed wages under the Code. The IRS may
    have sought to recover these amounts from Dern’s employer. As
    an underlying point for employers, FICA is owed on all payments
    made by an employer to an employee. Further, all wages are subject
    to withholding. This includes all compensation rendered as the
    result of a judgment or settlement and includes both backpay and
    front pay (however, the 5th Circuit does not treat front pay as
    wages, see Doston v. U.S., 87 F.3d 682 (5th Cir.
    1996)).

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.

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