Sixth Circuit Finds False Imprisonment Settlement Payments Taxable

BY NELL ADKINS, CPA, PH.D. AND RICHARD A. TURPEN, CPA, PH.D., CFE

The Sixth Circuit affirmed a Tax Court decision that settlement proceeds received for false imprisonment were not excludable under IRC § 104(a)(2) as amounts received due to physical injury.

 

Brenda Stadnyk was falsely imprisoned as the result of an auto dealership’s criminal complaint against her. She had stopped payment on a check to the dealership after a used car she bought there broke down the first time she drove it. Her bank incorrectly marked the check refused for insufficient funds and returned it to the dealership. Though these charges were later dropped, Stadnyk was arrested and detained about eight hours. Stadnyk testified that she was not hurt or abused during her arrest and detention. She paid no medical expenses as a result of the imprisonment, but she did see a psychologist for several sessions. She sued the auto dealership and her bank, Bank One, for malicious prosecution, abuse of process, false imprisonment, defamation and outrageous conduct. She also sued Bank One for breach of fiduciary duty of care.

 

Upon the assurances of their legal counsel and other attorneys in the mediation process that ensued, Stadnyk and her husband excluded from their 2002 self-prepared joint income tax return the $49,000 settlement payment they ultimately received from Bank One. The settlement agreement did not indicate why the settlement was paid, and the Sixth Circuit pointed out the Tax Court’s finding that all of Stadnyk’s damages were stated in terms of recovery for nonphysical personal injuries.

 

In its examination, the Sixth Circuit cited the Schleier (515 U.S. 323 (1995)) two-prong test for exclusion under section 104(a)(2) (see also Treas. Reg. § 1.104-1(c)): (1) that the underlying cause of action giving rise to the recovery is based upon tort or tort-type rights, and (2) that the damages are sustained through personal injuries or sickness. Section 104(a)(2) requires the injuries or sickness to be physical and expressly excludes emotional distress as a physical injury. The Sixth Circuit concurred with the Tax Court conclusion: that Mrs. Stadnyk’s legal action was based in tort-type rights but her settlement was received for emotional damages and not due to a personal physical injury. (Note that proposed amendments to Treas. Reg. § 1.104-1 (REG-127270-06, issued Sept. 15, 2009) to reflect the “physical” requirement added to the statute in 1996 would also remove the “tort or tort-type rights” requirement from the regulations.)

 

The court also rejected an argument by the Stadnyks that the settlement should be excluded because it was compensatory, as well as their challenge to the constitutionality of section 104(a)(2).

 

  Stadnyk v. Commissioner , docket no. 09-1485 (6th Cir., 2/26/2010)

 

By Nell Adkins, CPA, Ph.D., and Richard A. Turpen, CPA, Ph.D., CFE, both of the University of Alabama–Birmingham.

 

More from the JofA:

 

 Find us on Facebook      Follow us on Twitter

 

SPONSORED REPORT

How to make the most of a negotiation

Negotiators are made, not born. In this sponsored report, we cover strategies and tactics to help you head into 2017 ready to take on business deals, salary discussions and more.

VIDEO

Will the Affordable Care Act be repealed?

The results of the 2016 presidential election are likely to have a big impact on federal tax policy in the coming years. Eddie Adkins, CPA, a partner in the Washington National Tax Office at Grant Thornton, discusses what parts of the ACA might survive the repeal of most of the law.

QUIZ

News quiz: Scam email plagues tax professionals—again

Even as the IRS reported on success in reducing tax return identity theft in the 2016 season, the Service also warned tax professionals about yet another email phishing scam. See how much you know about recent news with this short quiz.