Settlement of workers’ comp claim partially excludable

BY CHARLES J. REICHERT, CPA

The Tax Court permitted a taxpayer to exclude 10% of her settlement from an employment suit against her former employer, because that portion of the settlement was compensation for her physical injuries and physical sickness and was a reasonable estimate of the amount.

Sec. 104(a)(1) excludes from income “amounts received under workmen’s compensation acts as compensation for personal injuries or sickness,” while Sec. 104(a)(2) excludes “the amount of any damages (other than punitive damages) received … on account of personal physical injuries or physical sickness.” In 2012, an amendment to Regs. Sec. 1.104-1(c) dropped a requirement that excludable damages under Sec. 104(a)(2) had to be based on tort or tort-type rights (see “Tax Matters: Regs. Finalized on Personal Injury Damages,” JofA, April 2012, page 63). When payments are received under a settlement agreement, their treatment is determined by the nature of the claim intended to be settled by the parties. However, if the intent of the parties cannot be determined, then an attempt is made to ascertain the payer’s intent.

Kathleen Simpson began working for Sears in 1972, eventually becoming a store manager in Fairfield, Calif., in 2000. In 2002, Simpson spoke with Sears’s district human resources manager and its district manager concerning physical ailments and depression caused by the demands of her job, with the hope of obtaining a transfer to another position. No transfer occurred, and Simpson was terminated in August 2002. She did not receive a California workers’ compensation claim form (or any related information) from Sears, and she never filed a workers’ compensation claim.

Simpson retained legal counsel and filed a lawsuit against Sears under California’s Fair Employment and Housing Act (FEHA), alleging employment discrimination, harassment, retaliation, and other claims. A state court dismissed three FEHA claims. It allowed one claim, that Sears failed to engage in an interactive process to reasonably accommodate a disability or medical condition, to proceed, but found that she could not prove that a transfer to another position would have been a reasonable accommodation. In 2009, the parties settled, solely on the issue of whether Sears failed to advise Simpson of her rights under California’s workers’ compensation laws as required. Simpson received $12,500 for lost wages and benefits, $98,000 for emotional distress and physical and mental disability, and $152,000 for attorneys’ fees and court costs. The settlement was never submitted for approval to the California Workers’ Compensation Appeals Board (WCAB), as required by California law.

Simpson and her husband excluded $250,000 of the settlement from income on their 2009 joint federal income tax return on the basis that it was a settlement of a lawsuit resulting from illness and disability, plus attorneys’ fees. The IRS issued a deficiency notice in 2011, and Simpson petitioned the Tax Court for relief.

After examining the evidence, the court concluded that the parties intended to settle Simpson’s workers’ compensation claim for her work-related personal physical injuries and sickness. The settlement agreement, however, did not comply with California’s workers’ compensation laws, because it was never submitted to the WCAB for approval. Thus, none of the payments could be excluded from Simpson’s income under Sec. 104(a)(1), since they were not received under a workers’ compensation act, according to the court.

The taxpayers then argued that 10% to 20% of the $98,000 should be excluded under Sec. 104(a)(2) because it was received due to a personal physical injury or physical sickness. The court agreed that the settlement had elements intended to compensate Simpson for her personal physical injuries or physical sicknesses. The court held that some or all of those workers’ compensation claims could be excluded, because amended Regs. Sec. 1.104-1(c), which could be applied retroactively by her, no longer required the settlement to be based on a tort or tort-type claim. Lacking evidence to be able to determine precisely how much of the settlement was attributable to the physical injuries, the court held that 10% of the $98,000 was made on account of the injuries and could be excluded.

After finding the testimony of Simpson and her attorney credible, the court also allowed an above-the-line deduction under Sec. 62(a)(20) for the entire $152,000 paid for attorneys’ fees and court costs involving an unlawful discrimination claim.

  Simpson, 141 T.C. No. 10 (10/28/13)

By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota–Duluth.

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