Emphasizing Physical Injuries In Settlement Agreements

The United States Tax Court (Court) recently issued a decision highlighting, yet again, the importance of clear drafting in settlement agreements. In Doyle v. Comm’r of Internal Revenue, T.C. Memo. 2019-8, the Court held that the taxpayer could not exclude amounts, pursuant to Internal Revenue Code § 104(a)(2), that he received from a settlement agreement.

Daniel Doyle worked at a tech company, Wacom, as a business consultant. When Wacom terminated his contract, Daniel’s overall health, which had been very good for most of his life, worsened for the very first time. He began experiencing a number of maladies, including chronic headaches, indigestion, insomnia, and a variety of body aches. The Court connected these physical maladies to Daniel’s emotional distress.

Following his termination, Daniel commenced an action against Wacom for breach of contract, antitrust violations, civil conspiracy, failure to pay wages, and wrongful discharge. The Court noted that Daniel’s Complaint did not mention anything about personal physical injuries, sickness, or even emotional distress. Instead of a drawn out arbitration or trial, the parties elected to quickly settle the matter.

In the settlement agreement, Wacom agreed to pay Daniel “$250,000 as settlement for his alleged emotional distress damages.” There was no mention that the $250,000 portion of the settlement related to any physical injuries or sickness. Instead, that $250,000 was related to Daniel’s alleged emotional distress. That was it.

I.R.C. § 104(a)(2) excludes amounts from taxable income that are received on account of personal injuries or sickness. I.R.C. § 104(a) specifically commands that emotional distress shall not be treated as a physical injury or sickness.

In determining whether the payments are received on account of personal injury, the Court first looks at the settlement agreement itself to see if it expressly states that the damages compensate for personal physical injury. If the settlement agreement is silent or ambiguous on this front, then the Court will look at all of the facts and circumstances of the case, including the Complaint and details surrounding the litigation, to try to determine the intent of the payor of the settlement amount.

The Doyle Court acknowledged that Daniel’s physical injuries likely were the result of his termination from the job. This acknowledgment seems to indicate that, if the settlement agreement or Complaint had stated that these physical injuries were the reason for the $250,000 portion of the settlement, then they may have been excludable pursuant to I.R.C. § 104. However, physical injury was not the language used in the settlement agreement. Instead, the settlement agreement noted that the $250,000 portion related to Daniel’s emotional distress.

Try as it might, the Doyle Court could not find any argument to support excluding the $250,000 because that portion of the settlement appeared to relate directly to Daniel’s emotional distress and I.R.C. § 104 is very clear as to the outcome in those circumstances. This highlights, yet again, the importance of using clear language when preparing and drafting a settlement agreement where physical injuries were a component of the settlement.

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