141 T.C. No. 10
Tax Ct.2013Background
- Kathleen Simpson sued Sears under California FEHA for employment discrimination; most claims were dismissed leaving one FEHA claim to proceed.
- Simpson’s counsel concluded the remaining FEHA claim had little value but discovered Sears had failed to provide workers’ compensation notices/forms, so Simpson could claim workers’ compensation benefits.
- Simpson and Sears entered a global settlement for $262,500 (net $250,000 reported on a 1099-MISC), allocating $12,500 to lost wages, $98,000 to "emotional distress, physical and mental disability," and $152,000 to attorney’s fees/costs; the agreement did not mention WCAB approval.
- Simpson never filed a workers’ compensation claim, and the settlement was not submitted to or approved by the California Workers’ Compensation Appeals Board (WCAB), as required by Cal. Lab. Code.
- Petitioners reported only the $12,500 as income; IRS issued a deficiency for the unreported settlement. Petitioners argued the settlement was excludable under I.R.C. §104(a)(1) (workers’ compensation) or §104(a)(2) (physical injury), and sought an above-the-line deduction under §62(a)(20) for attorney’s fees.
Issues
| Issue | Simpson's Argument | Sears/IRS Argument | Held |
|---|---|---|---|
| Whether settlement is excludable under I.R.C. §104(a)(1) as amounts received under a workers’ compensation act | Settlement compensated workers’ comp claims; thus excludable | Settlement lacked WCAB approval so it was a private contract payment, not payments under the State act | Not excludable — §104(a)(1) inapplicable because parties did not obtain required WCAB approval |
| Whether portion is excludable under I.R.C. §104(a)(2) as damages on account of personal physical injuries/sickness | 10–20% of the $98,000 (physical injuries) qualifies as non-taxable §104(a)(2) recovery | IRS relied on pre-2012 tort-type test and argued limits, but new regs allow exclusion if payment is for physical injury | Court applied amended regs and held 10% of the $98,000 is excludable under §104(a)(2) |
| Whether attorney’s fees and costs ($152,000) are deductible above-the-line under I.R.C. §62(a)(20) | Entire $152,000 reflects fees and reimbursed costs and is deductible | IRS conceded part but contested full amount; argued only $113,985.60 was fees received by counsel | Deduction allowed for full $152,000 based on credible evidence showing $113,985.60 fees + $38,014.40 reimbursed court costs |
| Burden of proof shift under I.R.C. §7491(a) | Petitioners requested shift after trial | IRS objected as untimely and unproven | Request denied; petitioners bore the burden of proof |
Key Cases Cited
- United States v. Burke, 504 U.S. 229 (settlement treated by asking “in lieu of what were the damages awarded?”)
- Commissioner v. Schleier, 515 U.S. 323 (§104(a)(2) requires damages on account of personal physical injuries or sickness)
- Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (definition of gross income)
- Rutter v. Commissioner, 760 F.2d 466 (payments must be pursuant to statute/regulation to qualify under §104(a)(1))
- Wallace v. United States, 139 F.3d 1165 (same principle that private payments are not §104(a)(1) unless statutory)
- Duberstein v. Commissioner, 363 U.S. 278 (payor’s intent central to characterizing payments)
- Steller v. Sears, Roebuck & Co., 189 Cal. App. 4th 175 (California appellate decision holding an unapproved compromise releasing WC claims is invalid without WCAB approval)
- Raischell & Cottrell, Inc. v. Workmen’s Comp. Appeals Bd., 249 Cal. App. 2d 991 (compromise invalid without statutory approval under California law)