Taxpayer Wrong About Tax Status of Award, but Court Found She Acted Reasonably Even Though Her Conclusion Was Wrong

Josephine Shelton had worked for Dial Corporation and while she was there she was sexually harassed by her supervisor. Complaints to higher management did not provide relief, and rather she was assigned menial labor or given the least desirable assignments. She developed severe emotional problems, and began to take medications to deal with the physical effects of her harassment.
Separately, the Equal Employment Opportunity Commission (EEOC) filed a sexual harassment complaint against Dial. In 2003, Dial entered into a consent decree where Dial would pay $10 million into a pool to be distributed to all eligible members. Josephine received $123,500 after signing a release that stated the payments were for “emotional pain, suffering, inconvenience, mental anguish, loss of enjoyment of life, and nonpecuniary losses. ” The release did not detail the federal tax treatment of the payment, but did have the recipient acknowledge that she was aware that some or all of the amount might be subject to federal and/or state tax.
Dial issued Josephine a 1099-MISC reporting this income for 2003. Josephine called the IRS help line to ask about the proper tax treatment and was informed by the person on the other end of the line that some awards, if they were for physical injuries, are not subject to tax. Josephine, having suffered physical effects from her harassment, determined that her award should not be subject to tax. She took her return to a tax preparer, and informed the preparer the award was to compensate her for a physical injury, and the return was prepared excluding the amount from income.
Unfortunately, the Tax Court noted that while Josephine may have suffered physical harm due to the harassment, the actual award was not based on her physical harm, but rather covered a wide range of potentially actionable causes. She was not compensated for her physical injuries and, as such, could not exclude the amount from income under §104(a).
However, the Tax Court denied the IRS’s attempt to assess Josephine an accuracy related penalty on the underpayment. It found that she had acted in good faith in attempting to properly report the payment (including consulting with the IRS) and, as such, the accuracy related penalty was not appropriate. Based on her knowledge of tax matters and the information she received from the IRS, her conclusion that the payment was not subject to tax was, while erroneous, quite reasonable.

Shelton v. Commissioner, TC Memo 2009-116

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