In Stassi v. Commissioner,1 the United States Tax Court found that a settlement was not excludable from income as a personal physical injury because the taxpayer failed to demonstrate that her shingles was caused by her employer's workplace.

The taxpayer had been employed for approximately two and a half years when she was diagnosed with shingles and had symptoms of shingles during her employment. A few months later, her supervisor placed her on a 30-day performance improvement plan (PIP). A few weeks after being placed on a PIP, the taxpayer went on an unpaid leave of absence until her resignation.

Three days after taking her leave of absence, the taxpayer sent a letter to a company board member complaining about the work environment. Although the letter contained a number of specific complaints, none included any complaints about physical injury or sickness. She subsequently retained an attorney who sent a demand letter alleging wage and hour violations, constructive termination, and "Emotional Distress and Punitives."

The taxpayer eventually settled with her employer for a payment of $80,000. The settlement recitals described the taxpayer's claims as follows: "[The taxpayer] claims she is owed wages and that she was constructively discharged and retaliated against for making certain complaints, * * * [and that] she has suffered emotional distress with physical manifestations of same." The words "physical manifestations," which had not been part of the taxpayer's initial complaint, were inserted into the settlement agreement during negotiations. The parties agreed that $10,350 was for lost wages, and the remaining $69,650 would be designated "consideration for physical manifestations of [the taxpayer's] emotional distress claims" reportable to the taxpayer on a Form 1099-MISC.

Tax Court Decision

The taxpayer filed her income tax return reporting the wage but only $1 of the $69,650. The IRS found that the entire $69,650 was taxable income and issued the taxpayer a deficiency assessment. The taxpayer then petitioned the Tax Court for relief.

The Tax Court started by noting that the definition of income is broad and exclusions narrow, and that the taxpayer is required to prove that the damages were received on account of personal physical injuries or personal physical sickness in order for them to be excludable from income under IRC section 104(a)(2).2 Specifically, the Tax Court noted, "there must be a direct causal link between the damages received and the physical injury or sickness sustained." Further, to justify exclusion from income under section 104(a)(2), the taxpayer must show that their settlement proceeds were in lieu of damages for physical injuries or physical sickness.

In order for the taxpayer to meet her burden of proof, the nature of the claim that was the actual basis for settlement guides the determination of whether such payments are excludable from income. In evaluating the nature of the underlying claim, a key question to be asked is: "In lieu of what were the damages awarded?" The determination is factual and based on the nature of the underlying claim. The court must consider the agreement in the light of all the facts and circumstances, including the claim's characterization under applicable state law, the evidence marshaled, the arguments made by the parties, and the intent of the payor of the settlement.3

Turning to the specific facts of the case, the Tax Court found that the mere insertion into the settlement agreement of the words "physical manifestations" was insufficient to establish that the payments were for a personal physical injury or sickness. Rather, the initial complaint to the board member and demand letter made no mention of personal physical injuries or physical sickness, referring only to "Wage and Hour," "Constructive Termination," and a multiplier for "Emotional Distress and Punitives." As a result, the Tax Court found that the taxpayer "failed to prove a causal link" between her claims and her shingles, and that while she established she had shingles, she "did not provide evidence that established that the occurrence of her shingles was related to or caused by her employment ...."

Employer Takeaways

While this case was about an individual's tax filing position, the facts of the case are a common fact pattern in employment-related litigation. In finding that there was no connection between the shingles and her employment that could support an exclusion from income for a "personal physical injury," the Tax Court reminds employers that they should not agree in settlements to treat damages as being "on account of" a personal physical injury without there being substantive factual support for that position. This requires careful consideration of the initial complaints raised by the plaintiff as well as care in drafting the settlement agreement. While in this case the employer correctly reported the payment as income on Form 1099-MISC, box 3 (other income), employers should not agree to forego reporting of non-wage payments for damages such as "emotional distress" unless there is clear factual support that the employer was the cause of an actual personal physical injury.

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