The taxation of legal settlements creates a lot of confusion, with taxpayers and their advisers not realizing that, most often, such settlements are going to be considered taxable income.  One such recent case is that of Tillman-Kelly v. Commissioner, TC Memo. 2022-111.[1]

The facts that led to Mr. Tillman-Kelly’s award are outlined in the opinion as follows:

In September 2009 CSU hired Mr. Tillman-Kelly as project director of a federal grant that CSU had received. Mr. Tillman-Kelly reported directly to Dr. Akujieze, a dean at CSU, and Robert Warner, the dean’s executive assistant. A few months into his employment Mr. Tillman-Kelly expressed concerns to the U.S. Department of Education and CSU’s Ethics Office that certain grant funds were being misappropriated. On June 17, 2010, CSU terminated Mr. Tillman-Kelly’s employment.

Mr. Tillman-Kelly thereafter filed suit against the Defendants in Illinois state court, alleging that they retaliated against him for his complaints of misuse of funds.2 He stated that he “was subjected to humiliation, isolation, harsher discipline and different and comparatively more negative terms and standards of employment, [than] other university employees, denial of benefits, demotions, and ultimately, termination.” Specifically, Mr. Tillman-Kelly asserted that Dr. Akujieze threatened to “do what he had to do” in response to Mr. Tillman-Kelly’s ethics complaints, which (again, according to the complaint) consisted primarily of eliminating Mr. Tillman-Kelly’s job responsibilities culminating with his termination.

Mr. Tillman-Kelly contended that these actions violated Illinois state whistleblower protections and sought “damages included but not limited to emotional distress and humiliation and lost income and benefits.” His complaint did not allege that he suffered any physical injuries, nor did he seek compensation for physical injuries.

Mr. Tillman-Kelly and the Defendants settled the state court case in 2017. Under the terms of the settlement agreement, Mr. Tillman-Kelly received a payment of $230,671 in exchange for ending his suit. The settlement agreement described this payment as being for “alleged non-wage injuries, as non-economic emotional distress damages.”[2]

The defendant reported the amount paid to Mr. Tillman-Kelly on a Form 1099-MISC, but the amount was not reported as income on the couple’s income tax return.  Not surprisingly, the IRS discovered this discrepancy and, eventually, issued a notice of deficiency to the taxpayers.

IRC §61 provides that “[e]xcept as otherwise provided in this subtitle, gross income means all income from whatever source derived…”.  Thus, we start from the assumption that the entire award constitutes taxable gross income to the taxpayer.

IRC §104(a)(2) provides one possible option for excluding the payment from Mr. Tillman-Kelly’s income, and this was what the taxpayers argued allowed them to exclude the payment from income.  The provision provides:

(a) In general. Except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical, etc., expenses) for any prior taxable year, gross income does not include--

…

(2) the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness;

In addition, the flush text at the end of §104(a) concludes with the following clarification of the §104(a)(2) exclusion:

For purposes of paragraph (2), emotional distress shall not be treated as a physical injury or physical sickness. The preceding sentence shall not apply to an amount of damages not in excess of the amount paid for medical care (described in subparagraph (A) or (B) of section 213(d)(1) attributable to emotional distress.

The opinion notes that the Court first looks at the underlying agreement to determine the nature of the claim:

The nature of the claim is typically determined by looking to “the underlying agreement to determine whether it expressly states that the damages compensate for 'personal physical injuries or physical sickness' under § 104(a)(2).” Rivera, 430 F.3d at 1257; see also Ghadiri-Asli v. Commissioner, T.C. Memo. 2019-142, at *38, aff'd sub nom. Najle-Rahim v. Commissioner, No. 20-72031, 2022 WL 2869776 (9th Cir. July 21, 2022).[3]

Tax advisers who have dealt with such agreements for taxpayers will note that most often the agreement does not provide such a nice, clear indication of what the damages were in compensation for, most often running into overly broad statements of what the payment was meant to compensate for.

In such a case, the Court notes that the inquiry then turns to the intent of the payor in making the settlement payment:

Should an agreement fail to answer the question, we inquire as to “the intent of the payor.” Devine v. Commissioner, T.C. Memo. 2017-111, at *11 (quoting Longoria v. Commissioner, T.C. Memo. 2009-162, 2009 WL 1905040, at *7); see also Rivera, 430 F.3d at 1257; Knuckles v. Commissioner, 349 F.2d 610, 613 (10th Cir. 1965), aff'g T.C. Memo. 1964-33; Ahmed v. Commissioner, T.C. Memo. 2011-295, 2011 WL 6440130, at *3, aff'd, 498 F. App'x 919 (11th Cir. 2012).[4]

It is important to note that the recipient’s belief about why the payment was made isn’t the key here, absent evidence that the taxpayer can provide that the payor shared that view.

The opinion then goes on to describe how the court will attempt to derive the payor’s intent if the agreement is ambiguous on the matter:

The payor’s intent may be discerned by taking into account “all the facts and circumstances of the case,” including the amount paid, the allegations in the injured party’s complaint, and the factual circumstances that led to the agreement. Rivera, 430 F.3d at 1257 (quoting Allum v. Commissioner, T.C. Memo. 2005-177, 2005 WL 1692488, at *4, aff’d, 231 F. App’x 550 (9th Cir. 2007)); see Green v. Commissioner, 507 F.3d 857, 868 (5th Cir. 2007), aff’g T.C. Memo. 2005-250; see also Bent v. Commissioner, 87 T.C. 236, 245 (1986), aff’d, 835 F.2d 67 (3d Cir. 1987). “Ultimately, the character of the payment hinges on the payor’s dominant reason for making the payment.” Green, 507 F.3d at 868. “[T]he nature of underlying claims cannot be determined from a general release [of claims] that is broad and inclusive.” Ahmed v. Commissioner, 2011 WL 6440130, at *3.[5]

In this case, though, the court found that the agreement expressly provided the payments were not for physical injuries of a type excludable under IRC §104(a)(2).

The settlement agreement establishes that the payment is not excludable under section 104(a)(2). The parties expressly agreed that the $230,671 payment to Mr. Tillman-Kelly was for “non-wage injuries, as non-economic emotional distress damages.” The parties do not reference physical injuries or sickness in the agreement, much less tie the settlement payment to any such physical injuries or sickness.[6]

The taxpayers argued that, despite what the agreement says, the real reason for the payment was rooted in physical injuries arising from an altercation between Mr. Tillman-Kelly and another employee:

The Tillman-Kellys respond that the retaliation claim was actually rooted in a heated altercation between Mr. Tillman-Kelly and Mr. Warner, which resulted in physical injury from the slamming of a door, and that the settlement proceeds were meant to compensate Mr. Tillman-Kelly for that injury. The Tillman-Kellys assert that their treatment of the proceeds was thus consistent with IRS Publication 4345, which states in relevant part that “proceeds you receive for emotional distress or mental anguish attributable to a personal physical injury or physical sickness are treated the same as proceeds received for Personal physical injuries or physical sickness.” I.R.S. Publication 4345 (Revised Nov. 2022), Settlements — Taxability, at 1.[7]

The opinion, however, notes that the agreement expressly provides for other reasons for the payment:

The settlement agreement belies the Tillman-Kellys’ position. In that agreement, the parties characterized the payment as one for “emotional distress damages” and did not reference any physical injury whatsoever.[8]

As was noted earlier, the settlement agreement’s language is the primary guide to the nature of the damage payment, thus the taxpayers’ case effectively ends when the agreement’s language clearly does not include such payments for physical injuries.

But the opinion goes on to note that even if the agreement had left some ambiguity with regard to why the payment was made, in this case the other evidence aside from the agreement was insufficient to show this altercation and the injuries arising from it are the primary motivation for the payment by the payor:

Even if we were to expand our focus beyond the settlement agreement, the Tillman-Kellys would fare no better. As an initial matter, Mr. Tillman-Kelly’s claim against the Defendants does not relate to compensation for physical injuries. The state court claim alleges violation of an Illinois whistleblower statute, describing a retaliatory campaign involving improper removal of job responsibilities and ultimately termination, not physical injury. Nor did Mr. Tillman-Kelly’s complaint seek damages for physical injury, instead pursuing damages for “emotional distress and humiliation and lost income and benefits.”

The only clear reference in the record to any physical injury comes in Mr. Tillman-Kelly’s responses to interrogatories in the state court action. In the context of a lengthy description of the events at issue and his complaints, Mr. Tillman-Kelly stated he reported to CSU ethics officials an incident in which Mr. Warner “slammed a door on [him] injuring [him].” Mr. Tillman-Kelly, however, did not identify this purported injury in response to an interrogatory asking for “the basis for any damages you claim to be entitled to, including the compensatory and punitive damages articulated in your Prayer for Relief.” Nor does the record explain the precise nature or extent of Mr. Tillman-Kelly’s purported physical injury from the door.[9]

Thus, the opinion concludes:

In short, we return to the plain text of the settlement agreement that the payment was made for “alleged non-wage injuries, as non-economic emotional distress damages.” This text is clear on its face, but even if there were some doubt, the nature of the state court litigation supports the conclusion that the dominant reason for the payment was to compensate for emotional distress and was altogether unrelated to physical injury.[10]

[1] Tillman-Kelly v. Commissioner, TC Memo. 2022-111, 11/21/22, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/payment-to-settle-retaliation-claim-not-excludable-from-income/7fdp0 (retrieved November 26, 2022)

[2] Tillman-Kelly v. Commissioner, TC Memo. 2022-111, 11/21/22

[3] Tillman-Kelly v. Commissioner, TC Memo. 2022-111, 11/21/22

[4] Tillman-Kelly v. Commissioner, TC Memo. 2022-111, 11/21/22

[5] Tillman-Kelly v. Commissioner, TC Memo. 2022-111, 11/21/22

[6] Tillman-Kelly v. Commissioner, TC Memo. 2022-111, 11/21/22

[7] Tillman-Kelly v. Commissioner, TC Memo. 2022-111, 11/21/22

[8] Tillman-Kelly v. Commissioner, TC Memo. 2022-111, 11/21/22

[9] Tillman-Kelly v. Commissioner, TC Memo. 2022-111, 11/21/22

[10] Tillman-Kelly v. Commissioner, TC Memo. 2022-111, 11/21/22