U.S. Tax Court Decision Shows Importance of Carefully Drafting Settlement Agreements

by Littler
Contact

In Sharp v. Commissioner,1 the United States Tax Court once again demonstrated the importance of carefully crafting settlement agreements and reaffirmed that emotional distress damages are taxable income to the recipient.

Background Facts    

The petitioner was a professor at the University of Northern Iowa.  She alleged that after she reported missing equipment, the university demoted her to a secretarial position in the Dean’s Office.  She subsequently took a leave of absence, and then sought reinstatement as a professor at the university.  After reinstatement, she again filed a report of missing equipment, which led to a yearlong grievance dispute between her and another faculty member.  She alleged her colleagues and supervisors were hostile to her and impeded her advancement and, therefore, her work life caused stress that ultimately led her to leave the university.  She alleged she developed muscle tension and migraine headaches, became afraid to go to the university, developed a fear of people, had nightmares and was eventually hospitalized for depression and diagnosed with severe clinical depression, anxiety disorder and post-traumatic stress disorder.  She did not return to work.

The petitioner brought a worker’s compensation claim and a separate action for gross negligence asserting that several colleagues had conspired to force her to quit her job.  She eventually entered into a settlement agreement with the university under which the university agreed to pay her settlement proceeds of $210,000 in three $70,000 installments.  The settlement agreement stated that the proceeds were for “emotional distress damages only.”  She received the first $70,000 in 2010, but instead of reporting it as income, attached a statement to her income tax return asserting that the income was exempt as a personal physical injury under Internal Revenue Code section 104(a)(2).  The IRS determined the payment was taxable and issued her an assessment.  She then filed a petition with the Tax Court.  The issues before the Tax Court were whether the $70,000 paid in 2010 qualified as income, and if so, whether the failure to report the income qualified for an accuracy-related penalty.

Tax Court’s Analysis

The petitioner argued that the payment was excluded as compensation received under a statute in the nature of a workers’ compensation, citing to the Iowa Worker’s Compensation Act (IWCA).  The IRS countered that the petitioner failed to prove that the settlement was paid in exchange for her settling a claim under the IWCA.  The Tax Court agreed.

It began by noting the basic rule that what the parties intended to compromise by entering into the settlement agreement is a question of fact that must be determined by reference to the agreement’s express language.  If the agreement fails to contain an express intent, the court must look at whether the payor in fact intended to settle a claim brought under a statute in the nature of a workers’ compensation statute.  The Tax Court found that the petitioner’s settlement agreement did “not indicate that the parties intended petitioner to receive the settlement proceeds in exchange for her settling a claim under the IWCA.”  The only reference in the settlement agreement to a workers’ compensation claim was a single reference to the agreement being conditioned on the petitioner “settling her ‘W.C. claim.’”  The Tax Court held that a “sole vague reference is insufficient to prove that the university paid petitioner the settlement proceeds in exchange for her settling a claim under the IWCA.”

The Tax Court further held that there was “scant evidence” in the record to support her contention, noting that it could not “bridge the logical gap between the evidence petitioner offered of her IWCA claims and a finding that the university paid the settlement proceeds in exchange for petitioner’s settling an IWCA claim.”  Rather, the Tax Court noted that “the record does not reflect that the IWCA claims were the only claims the university could have considered when entering into the settlement agreement.”  Thus, other claims brought against the university could have been considered in settling her claims, which would have been attributable to non-IWCA claims.  The court stated: “[w]ithout this missing link we are unable to conclude how much, if any, of the settlement proceeds may have been paid in exchange for petitioner’s settling an IWCA claim.”

The petitioner also argued that the payment was excludable from income as a payment on account of her emotional distress attributable to a physical injury or physical sickness.  The Tax Court rejected this argument, noting again that she failed to prove that the university paid her the settlement proceeds on account of her physical injuries or physical sickness when the settlement agreement expressly states that the university would pay the settlement proceeds to the petitioner for emotional distress damages only.

The Tax Court also pointed out that even if it could accept her evidence of a linkage, the petitioner still failed to demonstrate that her emotional distress resulted from a personal physical injury, citing several cases holding that emotional distress, even when coupled with physical manifestations, is an insufficient basis on which a taxpayer may exclude settlement proceeds from gross income.

Lessons for Employers

While this case arose in the context of a plaintiff’s failure to report income to the IRS, it provides several important lessons for employers.

  • Do not assume a general settlement without clear intent or allocation will be respected by the IRS or the courts.
  • Clearly express the intent of the parties in a written settlement agreement.
  • Carefully allocate the amounts to be paid for each kinds of damage for all claims being settled (including wages for claims for back pay, emotional distress on claims for harassment or discrimination, liquidated damages or other penalties provided by statute, attorney’s fees, etc.).
  • Properly report all payments to the extent required, which includes reporting emotional distress damages as income on an IRS Form 1099-MISC, box 3 (other income).

1Sharp v. Commissioner, TC Memo 2013-290.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Littler | Attorney Advertising

Written by:

Littler
Contact
more
less

Littler on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Custom Email Digest
Privacy Policy (Updated: October 8, 2015):
hide

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.

Security

JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at info@jdsupra.com. In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at: info@jdsupra.com.

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.