In the case of Duffy v. United States, US Court of Federal Claims, 115 AFTR 2d ¶2015-438 the taxpayers were looking to either exclude $50,000 in a legal settlement from income or have it taxed as capital gains—and they succeeded in neither attempt.

Mr. Duffy had been working as a consultant and was hired by the employer to attempt to help them comply with accounting rules upon the enactment of the Sarbanes-Oxley Act. Mr. Duffy observed activity he believed was in violation of the Act and carried forward a protest to management of the entity. He was placed on administrative leave shortly thereafter.

Mr. Duffy had filed a claim with the United States Department of Labor claiming illegal employment discrimination in retaliation for his complaints that his employer was acting in violation of provisions of the Sarbanes-Oxley Act. He entered into a settlement with his former employer just before the complaint was to be heard by an Administrative Law Judge that resulted in payment of $50,000 to Mr. Duffy.

The settlement agreement provided, per the court opinion:

[UCB] has entered into this Agreement for the exclusive purpose of avoiding the expense and inconvenience of further litigation. This Agreement shall not be deemed, at any time or in any forum, as an admission by any person or entity released by this Agreement of liability to, or the validity of any claim, by [Mr.] Duffy.

While Mr. Duffy initially reported the entire $50,000 as taxable income, he later filed two amended individual income tax returns related to this filing. In the first he simply claimed the amount should not have been income, while in the second he indicated that it was not taxable either because:

Mr. Duffy had suffered physical injury and sickness as a result of the discrimination which would excludable under §104 or
The payment was for purchase of the personal goodwill he claimed was damaged because he was unable to obtain work afterward, since he could not obtain a reference from the old employer. This would result in capital gain income from the sale of a capital asset as defined in IRC §1221. As Mr. Duffy had a large capital loss carryforward, this gain would be fully absorbed by that loss, resulting in no current tax.

The Court refused to accept either theory.

On the issue of exclusion due to physical injury or sickness, the Court notes:

The Duffys posit that the general release language in the Settlement Agreement is ambiguous as to the purpose of the payment, and therefore the court should look primarily to the intent of the parties. Pls.' Opp'n at 2. This argument is unavailing because the terms of the settlement agreement unequivocally resolve whether $50,000 in compensation was made "on account of' Mr. Duffy's physical injuries. Paragraph 8 of the Settlement Agreement states that Mr. Duffy was paid for "the exclusive purpose of avoiding the expense and inconvenience of further litigation." Agreement if 8 (emphasis added); cf Green, 507 F.3d at 868 (finding that paragraphs four and six in a settlement agreement contain express language of purpose). No language in the Settlement Agreement suggests that the proceeds were for the purpose of settling a claim for physical injury or physical sickness. See Pipitone, 180 F.3d at 864 ("The [s]ettlement [a]greement is a general release of all claims and makes no specific reference to whether the payment compensated [the taxpayer] for personal injuries or sickness."); cf Abrahamsen, 228 F.3d at 1363 ("Rather than reflecting an individualized amount for each employee based on the unique individual injuries of that employee, the payments reflected an amount associated with the employee's work record."). "And failure to show the specific amount of the payment allocable to the claims of tort or tortlike damages for personal [physical] injuries results in the entire amount's being presumed not to be excludable." Wise v. Commissioner, 75 T.C.M. (CCH) 1514 (T.C. 1998) (citing Taqqi v. United States, 35 F.3d 93, 96 (2d Cir. 1994); Getty v. Commissioner, 91 T.C. 160, 175-76 (1988), aff'd on this issue and rev 'don other issues, 913 F.2d 1486 (9th Cir. 1990)). Accordingly, payment to Mr. Duffy was "completely independent of the existence or extent of any personal [physical] injury." Schleier, 515 U.S. at 330.

The Court also found the language of the settlement precluded treatment as a sale of a capital asset.

The Court noted:

The terms of the Settlement Agreement do not evince a disposition or sale of business goodwill. Rather, as discussed supra, the payments were for "the exclusive purpose of avoiding the expense and inconvenience of further litigation," Settlement Agreement~ 8, and Mr. Duffy was "solely responsible for any tax liabilities occasioned by [UCB]'s payment of the consideration for this Agreement," id.~ 7, cf Scheible v. Commissioner, 71 T.C.M. (CCH) 3166 (T.C. 1996), aff'd, 130 F.3d 1388 (10th Cir. 1997) (holding that extended earnings payments were not proceeds from the sale of goodwill since "there was no express sales agreement, nor was there any evidence of vendible business assets."); Erickson v. Commissioner, 64 T.C.M. (CCH) 963 (1992), aff'd, 1 F.3d 1231 (1st Cir. 1993) (finding that settlement payments did not constitute a sale of capital assets because the record "contain[ ed] no express sales agreement, nor [did] it contain evidence of vendible business assets."). As in Scheible and Erickson, whatever goodwill or business reputation Mr. Duffy had as a consultant, he retained when he signed the Settlement Agreement. See Vaaler v. United States, 454 F.2d 1120, 1123 (8th Cir. 1972). Mr. Duffy may have intended to treat the payment of $50,000 as compensation based on "the damage inflicted on his [consulting] business," Pls.' Sur-reply at 23, but "once having accepted the [Settlement Agreement] in its form, he 'must accept the tax consequences of his choice, whether contemplated or not, ... and may not enjoy the benefit of some other route he might have chosen to follow but did not,"' Scheible, 130 F.3d at 1395 (quoting Commissioner v. National Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 149 (1974) (citations omitted)); see also Def.'s Mot. at Ex. 10 (citing Rev. Rul. 74-251, 1974-1 C.B. 234 (1974)).

This decision is consistent with a number of previous cases—taxpayers who receive legal settlements need to clearly demonstrate that a payment was for an excludable purpose (or in this case, alternatively, for the sale of a specific asset) in order to obtain preferential tax treatment.

In this case Mr. Duffy, by deciding to sign the agreement which specifically provided for an exclusive reason why the payment was being made, gave up any such claims. Attempting to “improve” the tax consequences by arguing later that the payment was for items not mentioned in the settlement agreement simply does not work.

If the agreement is vague as to what it covers, taxpayers may be able to point to specific claims brought up prior to the settlement to show why the agreement was signed. But even then, the taxpayers have an uphill battle unless it’s clear that the settlement was specifically and particularly related to an excludable item such as physical injury under IRC §104.

Similarly, to obtain capital gain treatment a taxpayer must show an actual sale of a capital asset. In this case the IRS did not dispute Mr. Duffy had a capital asset (personal goodwill), just that the settlement was not a sale of such an asset.