Lawsuit Settlement Held to Be Fully Taxable, No §104(a)(2) Exclusion Available

Justin Hansen had some serious problems with his supervisor at a mine owned by Martin Marietta Materials that began, at least per the record in this case, with an assault that involved pushing Justin to the ground and pushing his face into limestone powder.

His relationship with the supervisor did not improve when, a few days later, Justin reported that his supervisor had engaged in an unsafe work practice to the assistant plant manager and Martin Marietta’s ethics hotline. His supervisor then showed up at Justin’s house and threatened and assaulted him there. This assault he reported to the police, the plant manager and the ethics hotline. In both assaults Justin sustained minor injuries.

Justin then went on to report the unsafe practice to the Mine Safety and Health Administration, who sent an inspector to the mine who cited Martin Marietta for unsafe practices. At the end of July Martin Marietta terminated Justin’s employment for being unable to communicate with his fellow employees.

Not terribly surprisingly, Justin instituted a legal action against Martin Marietta for these actions, and the ultimate result with a settlement for $120,000 that was divided up into two parts: $20,000 was to be for back wages and $100,000 was attributable to Justin Hansen’s claims of emotional distress and his attorney’s fees. The agreement also stated that latter portion would be reported on a Form 1099 and not be subject to withholding. The issue in this case is whether the $100,000 was subject to taxation.

Justin held the amount was not subject to taxation, citing §104(a)(2). That provision holds that income does not include “(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.”

The Court did not agree. While it held that, based on the record, “It is not clear why the parties to the settlement agreement characterized that $100,000 amount as attributable to petitioner’s “claims of emotional distress” and attorney’s fees,”  the Court held that, having done that, Justin was bound by that characterization of the award. As well, there was no evidence that the $100,000 was limited to compensating him for only the physical injuries arising from the two assaults. As such, the amounts must be included in income.

Case law has made it rather clear that the §104(a)(2) exclusion is a narrow one, and for an award to be excludable it must clearly relate to physical illness or injury and that alone. If a client is involved in a dispute involving claims that include physical injuries, we can be of service in advising on the likely tax impact of any proposed settlement language.

As well, if a client receives a settlement, it’s important that we, as tax advisers, see the actual settlement agreement and other filings in the case related to the taxpayer’s claims before settling on our advice to the client about the viable positions on the taxation of the matter. In order to assure no rock is left unturned, litigants often assert a long litany of claim theories to justify their right to an award when pursuing litigation, and defendants will similarly require language broadly covering every possible claim to be covered by the settlement.

Unfortunately, when looking at §104(a)(2) exclusion, the IRS and courts are looking for a very specific claim that is being settled for a very specific amount, making these cases problematical.

The case is Hansen v. Commissioner, TC Memo 2009-87.

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