The tax treatment of legal settlements can be confusing for individuals who receive them, especially when they involve employment-related claims. One such issue was the subject of the Tax Court case Montes v. Commissioner,[1] which examined whether payments from an employment suit could be excluded from income.

Please note that this is a transcription of the oral findings, so there may be some grammatical errors or awkward expressions in the opinion. However, you should be able to understand the intended meaning without much difficulty.

Legal Settlements and Federal Income Taxes

The starting point for determining whether an item constitutes taxable income under the Internal Revenue Code is the broad definition in Internal Revenue Code (IRC) Section 61(a). This section states, generally, that “gross income means all income from whatever source derived” and income is essentially any increase in wealth. Under this definition, a legal settlement would qualify as income and be subject to tax. However, Section 61 is subject to exceptions that are provided by other sections of the IRC, which may exclude certain increases in wealth from taxable income.

The next question is whether there is any section of the IRC that could provide an exclusion for a legal settlement from taxable income. A possible candidate is IRC §104(a)(2), which states:

§104. Compensation for injuries or sickness

(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;

The main issue in this case was whether Ms. Montes’s award qualified for the exclusion from income under IRC §104(a)(2). She argued that it did, while the IRS disagreed and taxed her on the full amount.

Harassment, Lawsuit and Settlement

The bench opinion summarizes the facts of Ms. Montes’s case, starting with how she applied for and got hired as a firefighter in San Francisco:

Ms. Montes was a pioneer for women in the San Francisco Fire Department and wanted to be a firefighter since she was a little girl. She was one of the few women to pass the exam to get into the Fire Academy. There were only a handful of women admitted to the Fire Academy and she was one of only about half that didn’t wash out from the Fire Academy.

Back in 2016, she received a coveted assignment to a firehouse in downtown San Francisco. Firefighters, of course, have to live and work as a team. Their job requires physical skill and actual bravery to perform. She was part of this team, but the other members of the team were all men, and they were not uniformly welcoming to her as a woman in their ranks.

In early 2016, she began work as a firefighter on a truck unit. This unit has particularly difficult chores of securing the roof of a building burning, perhaps venting gases to allow suppression of the fire; it’s extremely dangerous work, and of course it requires the members of the team to be able to trust each other and work together.[2]

The bench opinion describes the harassment that Ms. Montes faced at work, which was severe and persistent, as the opinion explains:

The other members of her team, at least many of them, did not welcome her. Within weeks, even days of the start of her tenure in the firehouse in downtown San Francisco, some of the male firefighters began making disparaging comments about her, sabotaged her equipment, making it difficult for her to speedily respond to calls. Ostracized her within the firehouse, and escalated into doing disgusting and extremely unsanitary things to her personal property.[3]

Ms. Montes tried to stop the harassment by complaining to superiors, but it did not end. She eventually filed a lawsuit and received a settlement, which was the subject of the tax dispute before the Court.

She did what one would expect. She complained up the chain. She complained to the chiefs within the firehouse itself, which only served to increase the harassment she was suffering from. She reasonable feared sabotage in a dire situation, which again, firefighters have to confront routinely in the course of their profession. She made complaints to higher authorities. It leaked out into the local press and her name became known locally as somebody who was making complaints about the conditions of her employment. Finally, in 2017, it led to her decision to file a lawsuit in Federal court to put an end to the harassment, and in June of 2018, that lawsuit was settled.[4]

The settlement included, among other things, a monetary payment that Ms. Montes received in 2018.

We’re here in Tax Court because of one of the terms of the settlement. One of those terms was a payment to Ms. Montes of $382,797.70 to her personally. The agreement also provided for attorney’s fees, but that’s not at issue here. The agreement was approved, and the payment was made and received in 2018. Ms. Montes returned to work and continues to this day as a firefighter working for the people of the City of San Francisco.

What is the Proper Tax Treatment of Ms. Montes’ Settlement Payment?

Ms. Montes sought professional advice from a CPA on how to report her settlement on her 2018 tax return. She followed the CPA’s recommendation that the settlement was not taxable income and did not include it in her 2018 income.

She went to a CPA when her taxes were due for 2018 and the CPA prepared her return and advised her that she did not have to report the $382,000 plus that she had received in the settlement, so she didn't report it. The Commissioner disagreed and issued a Notice of Deficiency. Ms. Montes was a California resident when she filed her petition. The only remaining issue after some other more minor issues were settled is the proper tax treatment of that nearly $400,000 payment.[5]

The judge points out that IRC §104(a)(2) is the relevant section for this case, which provides an exclusion for certain types of settlements:

Section 61(a) of the Internal Revenue Code says that “(Gross income means all income from whatever source derived.” And the Supreme Court has repeatedly emphasized the sweeping scope of this section and its statutory predecessors. Commissioner v. Schleier, 515 U.S. 323, 327 (1995). This robust rule of taxability has exceptions. The one we have to consider here is section 104(a)(2), which excludes from gross income “any damages other than punitive damages received whether by suit or agreement and whether is lump sums or is periodic payment on account of personal, physical injuries or physical sickness.”

Settlement proceeds are excludable under section 104(a)(2) only if the settlement is paid “on account of personal physical injuries or physical sickness.” Rivera v. Baker W., Inc., 430 F.3d 1253, 1256 (9th Cir. 2005). For a taxpayer to fall within this exclusion, she must show that there is a direct causal link between the damages and the personal injuries sustained. Where as here, a taxpayer settles a suit, we look at the nature of the claim that was the basis of the settlement. United States v. Burke, 504 U.S. 229, 237 (1992).

We looked, first, at the settlement agreement itself to see if “it expressly states that the damages compensate for internal ‘personal physical injuries or physical sickness’.” Rivera, 430 F.3d at 1257. If the settlement agreement is silent, we try to figure out the intent of the payor from all the facts and circumstances of the case, including the complaint that was filed and the details surrounding the litigation.[6]

The judge concludes that the settlement agreement itself settles the issue—and not in the taxpayer’s favor.

Our detective work here begins and ends with the settlement agreement. It says that the payment to Ms. Montes of nearly $400,000 “will be considered and treated as general damages for personal injury, including allegations of emotional injury. This amount will not be considered or treated as back wages.” Similarly, two paragraphs down, “the parties understand and agree that the settlement amount is inclusive of all of plaintiff’s claimed general damages, including emotional distress, special damages, and attorney’s fees and costs.”[7]

The taxpayer’s complaint does not help her case, as it does not claim any physical injuries or request any damages related to such injuries or illnesses.

Even if we were to look at the complaint, it too stresses that no physical injuries were alleged. The first claim for relief was for sex discrimination. The second for retaliation under California law. The third for sex discrimination under Federal law. The fourth for retaliation under Federal law. The fifth, the failure on the part of the Fire Department to prevent discrimination against Ms. Montes. And the sixth, the intentional infliction of emotional distress.

There are no allegations of physical injury to Ms. Montes, and indeed, in the summary of the complaint it says, "She has lost compensation for which she would have been entitled. She has suffered from emotional distress, embarrassment, and humiliation and her prospects for career advancement have been diminished." She sought compensatory damages, including future wages, employee benefits, and damages for mental and emotional distress, damage to her reputation, and humiliation. There are no allegations of physical disease or harm to her in the complaint.[8]

You might wonder if emotional distress counts as a physical injury or physical sickness for the purpose of the exclusion. However, the opinion notes that both Congress and previous case law have ruled out that possibility.

This leads to the next question, which is, is alleged emotional distress a personal physical injury or physical sickness? Here, the Code tells us that it isn't. Section 104(a) specifically commands that "emotional distress shall not be treated as a physical injury or physical sickness" and case law tells us that emotional distress includes symptoms such as insomnia, headaches, and stomach problems that result from such severe emotional distress. See Pettit v. Commissioner, T.C. Memo. 2008-87.[9]

The judge ends by acknowledging that the current scientific knowledge of psychiatry and neurology may not support this view, but the law enacted by Congress must prevail in this case:

While I have noted in previous opinions about the crumbling barrier between psychiatry and neurology. Where the Code itself assumes a dualist view of mind and body, we must assume such a view as well when we apply the Code to the facts of the particular case.[10]

Penalties Do Not Apply as Ms. Montes Acted Reasonably in Arriving at the Position on Her Return

The judge decided that it was not fair to impose an accuracy-related penalty on Ms. Montes in this case. She explains:

I can’t fault Ms. Montes for the position that she took, but section 104 says that this payment has to be included in her taxable income. Certainly, she wouldn’t have had to pay a penalty. She took a reasonable position on the advice of a CPA.[11]

Even though the CPA’s conclusions may not have the ones the court arrived at, the fact that Ms. Montes sought professional advice from a professional who appeared qualified to properly analyze this issue and who had no obvious incentive to provide her with the answer the income wasn’t taxable if it was protected her from owing an additional 20% penalty on the tax imposed.

It would have been better if the CPA had found the restriction on excluding emotional distress as a physical injury or illness in Section 104(a) and told Ms. Montes that the payments were taxable. However, the taxpayer is not penalized because sometimes the adviser may make a mistake, despite the taxpayer’s good faith and reliance on professional advice.

[1] Montes v. Commissioner, US Tax Court Bench Opinion, Docket No. 17332-21, June 29, 2023, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/firefighter%e2%80%99s-discrimination-settlement-not-excluded-from-income/7gxny (retrieved June 30, 2023)

[2] Montes v. Commissioner, US Tax Court Bench Opinion, Docket No. 17332-21, June 29, 2023

[3] Montes v. Commissioner, US Tax Court Bench Opinion, Docket No. 17332-21, June 29, 2023

[4] Montes v. Commissioner, US Tax Court Bench Opinion, Docket No. 17332-21, June 29, 2023

[5] Montes v. Commissioner, US Tax Court Bench Opinion, Docket No. 17332-21, June 29, 2023

[6] Montes v. Commissioner, US Tax Court Bench Opinion, Docket No. 17332-21, June 29, 2023

[7] Montes v. Commissioner, US Tax Court Bench Opinion, Docket No. 17332-21, June 29, 2023

[8] Montes v. Commissioner, US Tax Court Bench Opinion, Docket No. 17332-21, June 29, 2023

[9] Montes v. Commissioner, US Tax Court Bench Opinion, Docket No. 17332-21, June 29, 2023

[10] Montes v. Commissioner, US Tax Court Bench Opinion, Docket No. 17332-21, June 29, 2023

[11] Montes v. Commissioner, US Tax Court Bench Opinion, Docket No. 17332-21, June 29, 2023