No Portion of Legal Settlement Excludable from Income—Taxpayer Could Not Establish What Portion, If Any, Related to Physical Injuries

In Save v. Commissioner, TC Memo 2009-209, a taxpayer attempted to exclude from income amounts she had received in settlement of litigation. She had alleged in her complaint a number of violations by the defendant, which included violation of her First Amendment rights, whistleblower retaliation, intentional and negligent infliction of emotional distress and defamation.

The defendant county settled with Mary Save, paying $500,000 to Mary and $750,000 to her attorneys. The Tax Court noted that the IRS conceded that the $750,000 was not income to Mary, but did claim she should have reported the $500,000 as income, which Mary did not do. Mary asserted that the emotional distress she suffered resulted in a physiological illness and that her settlement proceeds were received on account of that illness. Under §104(a)(2) such a payment would be excluded from income.

However the Tax Court pointed out that the settlement itself contained no such language stating the payment was specifically for such injuries, containing only a very general reference to Mary’s claims against the county and did not allocate the award. As well, Mary showed no other evidence that the county intended by paying the award for some or all of the proceeds to directly relate to the physical illness.

The Tax Court cites a number of cases that make clear that a taxpayer claiming damages related to claims excludable under §104(a)(2) must provide clear evidence that some or all of the amounts received were specifically allocated to such claims―the mere inclusion of such claims along with other causes of action, and a settlement that deals with all potential claims is not sufficient to obtain relief from inclusion.

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