Employment-Tax Court Rules That Proceeds From A Settlement Agreement Are Not Taxable Under Section 104(a)

In Domeny v. Commissioner of Internal Revenue, T.C. Memo. 2010-9, the taxpayer had entered into a severance and claims release agreement (the “settlement agreement”) with her former employer, to settle her claim that she had been illegally terminated from employment because of her medical condition (multiple sclerosis). The taxpayer received, among other amounts, $16,033 from this settlement. The Tax Court was faced with the question of whether this $16,933 amount is excludable from her gross income under section 104(a)of the Internal Revenue Code.

Section 104(a) provides, in pertinent part, that gross income does not include the amount of any damages received on account of personal physical injuries or physical sickness. For section 104(a) to apply in the case of a settlement agreement: (1)the taxpayer’s claim being settled must be based on tort or tort rights-a matter not in dispute here-and (2)the amount of damages must be paid to compensate the taxpayer for physical injuries or physical sickness. As to prong (2), the Tax Court said that when amounts are paid under a settlement agreement, the Court first examines the agreement to see if it expressly states that the amounts were paid as compensation for personal physical injuries or physical sickness. If-as in this case- the agreement is ambiguous or lacks express language on this point, the Court then examines the intent of the payor.

Here, the $16,933 amount was paid by the former employer to the taxpayer, and the payment was not reduced by any tax withholding. The employer also issued a Form 1099-MISC to the taxpayer, indicating that the $16,933 amount was “nonemployee compensation”. The Tax Court felt that the manner of making and reporting this payment, coupled with certain other factors (including how other payments made to the taxpayer under the settlement agreement were reported (or not reported)), shows that the former employer was aware that the $16,933 amount was paid due to the taxpayer’s physical illness. The Tax Court concluded that the $16,933 amount was paid to compensate the taxpayer for her physical illness, and was therefore not taxable under section 104(a).

Comment: Even though the taxpayer prevailed here, to help ensure that a payment under a settlement agreement can qualify for the tax exclusion under section 104(a), the settlement agreement should expressly state that the payment is being made as compensation for physical injury or physical illness, as the case may be.