Payments a woman received under a voluntary egg-donation contract could not be excluded from income as damages for physical injury or sickness under Sec. 104(a)(2).
The Tax Court held that a woman could not exclude from gross income the payments she received under contract for pain and suffering she experienced from providing her eggs to infertile women under two egg-donation contracts. Although the contracts clearly stated the payments were in part for pain and suffering, the amounts were not damages under Sec. 104(a)(2) because the payments were compensation for an advance waiver of damages, according to the court.
Facts: During 2009, Nichelle Perez signed two egg-donation contracts with The Donor Source, a California for-profit company that matches egg donors with women and couples who are attempting to have a child. As part of the egg-donation process, Perez was required to complete certain medical procedures at her home and in a clinic, in return for which she would be compensated for her time, effort, inconvenience, and pain and suffering during the process. Payment was not contingent upon Perez’s producing usable eggs, nor was it for the sale of body parts. In 2009, she went through the egg-donation process twice, causing her significant pain, discomfort, and distress. She received $10,000 for each egg donation and later received a 2009 Form 1099 for $20,000. Perez did not report the $20,000 on her 2009 federal income tax return and later received a deficiency notice from the IRS. She petitioned the Tax Court for relief.
Issues: Sec. 104(a)(2) excludes from gross income any amount of damages (other than punitive damages) received because of physical injuries or physical sickness. The excludable damages can be received from a lawsuit or from an out-of-court settlement and can be received either periodically or as a lump sum. Regs. Sec. 1.104-1(c)(1) defines damages as an “amount received (other than workers’ compensation) through prosecution of a legal suit or action or through a settlement agreement entered into in lieu of prosecution.”
The taxpayer argued that the payments were for the pain, suffering, and physical injuries she suffered because of the egg-donation process and that the amount should be excluded from income under Sec. 104(a)(2) despite the fact that she did not receive the payments in a lawsuit or under threat of a lawsuit. She contended that the regulation’s requirement of a lawsuit or a threat of a lawsuit was an impermissible interpretation of the statute. The IRS argued that the payments were compensation for services and thus taxable.
Holding: The court believed that Perez endured pain and suffering from personal injuries, but because she signed a voluntary contract in advance of those injuries under which she received compensation for them, the payments were received from a waiver, rather than damages. The court added, “We see no limit on the mischief that ruling in Perez’s favor might cause,” citing professional athletes, construction workers, farmers, and ranchers, all of whose compensation reflects a risk that they may endure pain and suffering by performing the services they agree to in their contracts. If the clinic or The Donor Source had exceeded the terms of the contract, an argument could be made the payments were damages; however, the clinic and The Donor Source did exactly what Perez consented to, so the payments were compensation for services, according to the court.
In 1996, an amendment to Sec. 104(a)(2) dropped a requirement that the excludable amounts must be based on some tort or tort-type claim, and, in 2009, the Sec. 104 regulations were also amended to reflect the change in the law. However, the Tax Court concluded that this did not affect the outcome in the taxpayer’s case. The Tax Court found that the amended regulations merely kept the tax law in alignment with the shift in American law from common law tort remedies toward administrative or statutory (no-fault) remedies.
By Charles J. Reichert, CPA , instructor of accounting, University of Minnesota–Duluth.