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Case Alert:  Taxpayer allowed partial Section 104 exclusion for workers’ compensation claim

The Tax Court has held in Simpson v. Commissioner, 141 T.C. No. 10, that a payment made from a corporation to a former employee to settle her workers’ compensation claims wasn’t excludible under Code Sec. 104(a)(1) because the settlement agreement failed to satisfy a key element of the state’s workers’ compensation laws. However, the Court found that a portion of the settlement was excludible under Code Sec. 104(a)(2) as recovery for personal physical injuries or physical sickness, and upheld the employee’s attorneys fee deduction in full.

Background. Gross income includes all income from whatever source derived (Code Sec. 61(a)), unless specifically excluded. Under Code Sec. 104(a)(1), “amounts received under workmen’s compensation acts” to compensate for personal injuries or sickness are excluded from income. Code Sec. 104(a)(2) excludes from income the amount of any damages (other than punitive damages) received (by suit or agreement) on account of personal physical injuries or physical sickness. When a taxpayer receives a payment under a settlement agreement, the nature of the claim that was the actual basis for settlement determines whether such payments are excludable from income.

Adjusted gross income means gross income less certain enumerated deductions. (Code Sec. 62(a)) One of these deductions is a deduction for attorney’s fees and court costs paid by, or on behalf of, a taxpayer in connection with any action involving a claim of unlawful discrimination. (Code Sec. 62(a)(20))

Facts. Kathleen Simpson began working for Sears in ’72 and performed various jobs over the years. In the late ’90s, she was promoted to manager of a small store, then promoted to a district-level merchandise manager position, and was then transferred to manage another Sears store in Fairfield, California. The Fairfield Sears was a significantly larger store than the one that Ms. Simpson had previously managed, and it was also a “problem store” that had, following the termination of the prior store manager and many employees, a generally inexperienced staff.

To deal with these store issues, Ms. Simpson worked long hours and engaged in strenuous physical activities which resulted in injuries to her shoulders, left knee, and neck. She become exhausted, lost 25 pounds, and considered committing suicide. She sought treatment and was ultimately diagnosed with clinical depression, irritable bowel syndrome, and fibromyalgia.

In March 2002 Ms. Simpson approached the district human resources manager, informed her of the diagnoses and the physical problems, and told the manager that her sickness was work-related and that, on the advice of her doctor, she wanted to transfer to another position. The human resources manager didn’t inform anyone within Sears of Ms. Simpson’s problems or tell anyone about her transfer request. After not hearing back, Ms. Simpson conveyed these issues and her transfer request to Sears’ district manager in June. Sears never transferred her and, in August, terminated her employment. She continued to suffer from depression and work-related physical injuries after her termination and remained unemployed for one year.

Ms. Simpson sued Sears for employment discrimination under California’s Fair Employment and Housing Act (FEHA), claiming that she was entitled to compensatory damages for, among other things, physical injuries. After the State court dismissed all but one claim alleged in the suit, her attorney concluded that she would not be able to extract a settlement from Sears on the basis of the one remaining FEHA claim. The attorney learned, however, that she was eligible for workers’ compensation benefits under state workers’ compensation laws.

On that basis, Ms. Simpson and Sears eventually entered into a settlement agreement by which she released Sears from “each and every claim” she might have against it, “including, but not limited to, claims asserted in” the FEHA lawsuit. However, the settlement agreement was silent as to her possible workers’ compensation claims. The agreement stated that $12,500 was paid to Ms. Simpson for her claim for lost wages and employment benefits; $98,000 was paid for her claims of emotional distress, physical and mental disability; and $152,000 to her attorney for fees and court costs. Her attorney understood that the $98,000 was intended to compromise her claim for workers’ compensation benefits for “emotional distress and physical and mental disabilities” that she suffered from work-related injuries, and he attributed 10% to 20% of the $98,000 to the work-related physical illness and disabilities that she suffered. Neither Ms. Simpson nor Sears submitted the settlement agreement to the California Workers’ Compensation Appeals Board (WCAB) for approval as required under state law.

Ms. Simpson and her husband timely filed a 2009 return reporting as income the $12,500 payment for lost wages. They attached a letter from the attorney explaining the nature of the remaining $250,000 and why he thought it didn’t need to be reported. IRS issued a deficiency notice that the $250,000 should have been reported as income.

Ms. Simpson argued that the $250,000 was excludible from gross income under Code Sec. 104(a)(1) as an amount received under California’s workers’ compensation laws. In the alternative, she argued that (i) up to 20% of the $98,000 allocated to “emotional distress and physical and mental disabilities” was excludible under Code Sec. 104(a)(2), and (ii) the $152,000 allocated to attorney’s fees and court costs was deductible under Code Sec. 62(a)(20).

Settlement wasn’t under workers compensation statute. The Tax Court first noted that the settlement agreement was ambiguous as to whether it was made to settle Ms. Simpson’s FEHA claims, her workers’ compensation claims, or both. Notably, the agreement broadly stated an intent to resolve “all claims raised” and other matters involving her former employment relationship with Sears, but it didn’t expressly include her workers’ compensation claim. On the facts of the case, the Court found that the parties intended for her workers’ compensation claims to be treated as covered by the settlement. It further found that a portion of the settlement was made to compensate her for work-related physical injuries and sickness.

However, the Court then pointed out that to be excludible under Code Sec. 104(a)(1), the payment must also be made “under a workers’ compensation act or under a statute in the nature of a workers’ compensation act that provides compensation to employees for occupational personal injuries or sickness.” Operative state law required the parties to seek WCAB approval of any release of or agreement to compromise an employer’s liability for workers’ compensation benefits, which didn’t happen here. Accordingly, the $250,000 was “merely payments made under a private contract” and not under any workers’ compensation act. Looking to a recent California state court decision, the Tax Court found that state law effectively conditioned the validity of any such agreement for state law purposes on WCAB’s approval. Thus, since the settlement wasn’t a valid agreement to settle her workers’ compensation claims under state law, the amount didn’t qualify for exclusion under Code Sec. 104(a)(1).

Alternative argument accepted. The Court then agreed with Ms. Simpson on her alternative claim that 10% to 20% of the $98,000 was excludible as an amount received on account of personal physical injuries or sickness. The Tax Court analyzed Code Sec. 104(a)(2) and its regs and found that a portion of the settlement was excludible thereunder because it was intended to compensate Ms. Simpson for personal physical injuries and sickness. On the basis of the record, the Court found that 10% of the settlement payment was excludible.

Finally, turning to the issue of attorneys’ fees, the Court concluded that the entire $152,000 was deductible. The Court rejected IRS’s argument to limit the deduction to $113,985.60 (i.e., the amount actually paid to the attorney), finding that the attorney’s testimony and overall facts of the case showed that the remaining $38,014.40 was used to reimburse Ms. Simpson for court costs that she incurred.

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Meet Paul Raymond

Meet Paul Raymond

Mr. Raymond is a sought after speaker in tax controversy law by many attorney, accountant, and business groups and at the request of the Internal Revenue Service, has presented programs at the IRS Nationwide Tax Forum, attended by tax professionals throughout the United States.

Additionally, he continues to be an active member in the Section of Taxation, American Bar Association, where he was the Past Chair of the Employment Taxes Committee.

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