Section 104 Exclusion and Wrongful Termination Settlements

The most recent edition of the EA Journal brought up a 2008 US Tax Court decision regarding section 104 and a wrongful termination lawsuit settlement.

In Ruch Suder v. Commissioner, the Tax Court reaffirmed numerous other decisions regarding the applicability of IRC Section 104 (Exclusion of Non-Punitive Damages for Physical Injury or Physical Sickness). From 2000 to 2001 Ms. Suder was employed as a sales representative for Adelphia and was inexplicably terminated by Adelphia in 2001. She filed a lawsuit alleging defamation and other violations of state and federal employment laws. The lawsuit was settled and she was paid 41,000 dollars with the stipulation that she would pay all of the associated taxes. Is the settlement excludible under for IRC Section 104?

The US Tax Court holds that lawsuit settlements do not qualify for IRC Section 104 exclusion unless the damages are associated with an actual physical injury or a physical sickness. The Tax Court rejected the petitioners claims that the defamation caused damage to Ms. Suder's reputation and that such damage caused mental pain and anguish and as such qualified as physical injury and sickness.

Before IRC Section 104(a)(2) was amended with the by the Small Business Job
Protection Act of 1996 (SBJPA), Pub. L. 104-188, sec. 1605(a) 110 Stat. 1838, the statute allowed the exclusion to include damages associated with physical injury and sickness. In Moulton v. Commissioner, the court stated the following regarding pre-SBJPA Section 104(a)(2):

The reference to personal injuries or sickness included
“nonphysical injuries to the individual, such as those affecting
emotions, reputation, or character”. United States v. Burke,
supra at 235 n.6; see Robinson v. Commissioner, 102 T.C. 116,
125-126 (1994), affd. in part and revd. in part on another issue
70 F.3d 34 (5th Cir. 1995).

After SBJPA, the statutory language of IRC Section 104(a)(2) was changed to “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”. There was also a subsequent amendment to SBJPA that further narrowed the scope of IRC 104(a)(2) to the following language:

“For purposes of paragraph (2), emotional distress
shall not be treated as a physical injury or physical sickness.
The preceding sentence shall not apply to an amount of damages
not in excess of the amount paid for medical care * * *
attributable to emotional distress.”

Therefore it appears that Congressional intent and the current legal interpretation of 104(a)(2) only permits the exclusion of damages received that are the result of actual bodily harm and an actual bodily sickness. The court will not exclude damages for emotional distress other than damages that are used directly for medical treatment of mental or emotional trauma.

It is interesting to see how narrow Congress made this exclusion. Not surprisingly, I'd assume this area must have been an area of taxpayer abuse prior to 1996. I wonder if this was a common theme in lawsuit settlement arrangements, lawyers likely made sure that emotional distress was mentioned in the damages in order to qualify for Section 104(a)(2) exclusion. The debilitating effects of emotional stress can be rather subjective especially when taxes and money are involved, and removing this exclusion likely has made a great deal of revenue for the Treasury.