141 T.C. 331
T.C.2013Background
- Kathleen Simpson sued Sears under California FEHA alleging workplace discrimination, emotional distress, and physical injuries; most FEHA claims were dismissed leaving one claim to proceed.
- Simpson’s attorney identified potential workers’ compensation exposure because Sears failed to provide required WC claim forms/notice; parties negotiated a global settlement without submitting the agreement to the California Workers’ Compensation Appeals Board (WCAB).
- Settlement allocated $12,500 to lost wages (reported as income), $98,000 to "emotional distress, physical and mental disability," and $152,000 to attorney’s fees and costs; petitioner never filed a WC claim nor obtained WCAB approval.
- IRS determined petitioners failed to report $250,000 and assessed a deficiency; petitioners conceded the penalty but argued exclusion under I.R.C. §104(a)(1) (workers’ comp) or §104(a)(2) (physical injury), and sought deduction of attorney fees under §62(a)(20).
- Tax Court found the settlement was intended in part to compensate workers’ compensation-type claims and physical injuries, but because the parties did not obtain required WCAB approval the payments were not "amounts received under workmen’s compensation acts" for §104(a)(1); it allowed exclusion of 10% of the $98,000 under §104(a)(2) and permitted deduction of the $152,000 in fees/costs under §62(a)(20).
Issues
| Issue | Plaintiff's Argument | Defendant's Argument | Held |
|---|---|---|---|
| Whether settlement is excludable under I.R.C. §104(a)(1) as workers’ compensation | Simpson: entire settlement arises from WC claims so excludable | IRS: no WCAB approval; thus not payments under WC act | Not excludable — no WCAB approval required by Cal. Lab. Code, so §104(a)(1) exclusion fails |
| Whether portion is excludable under I.R.C. §104(a)(2) as damages for physical injury | Simpson: 10–20% of $98,000 compensates physical injury and should be excluded | IRS: workers’ comp settlements traditionally not tort-based and thus not excludable absent tort; but new regs apply | Excludable: 10% of $98,000 excluded under §104(a)(2) per revised regs focusing on physical injury rather than tort framework |
| Proper allocation/amount attributable to physical injury | Simpson: 10–20% attributable; attorney testified similarly | IRS: disputes allocation/extent | Court used best judgment and found 10% attributable to physical injuries |
| Whether attorney’s fees and costs ($152,000) are deductible under I.R.C. §62(a)(20) | Simpson: full $152,000 deductible as fees/costs in discrimination action | IRS: conceded deduction in part; contested actual amounts received by attorney | Deductible: $152,000 allowed under §62(a)(20) based on credible evidence (court costs $38,014.40; fees $113,985.60) and respondent’s concession |
Key Cases Cited
- Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (Sup. Ct.) (broad definition of gross income)
- United States v. Burke, 504 U.S. 229 (Sup. Ct.) (inquiry into "in lieu of what" damages were paid for §104 purposes)
- Commissioner v. Schleier, 515 U.S. 323 (Sup. Ct.) (limits §104(a)(2) to damages on account of personal physical injuries or sickness)
- Rutter v. Commissioner, 760 F.2d 466 (2d Cir.) (payments must be pursuant to statute/regulation to qualify under §104(a)(1))
- Wallace v. United States, 139 F.3d 1165 (7th Cir.) (requirement that payments arise under rule of general applicability for §104(a)(1))
- Steller v. Sears, Roebuck & Co., 189 Cal. App. 4th 175 (Cal. Ct. App.) (WCAB approval requirement renders compromise of WC claim invalid until approved)