Tax Court Deems Employment Settlement Taxable Yet Again

Navigating Tax Implications of Employment Settlements

In a recent turn of events, the Tax Court has reasserted its long-time position on the taxation of employment settlements, yielding noteworthy implications for plaintiffs and their attorneys. Understanding this court ruling and the options available with any employment settlement can provide invaluable insights for both attorneys and individuals grappling with their tax implications.?

The Tax Court's Verdict and Its Impact

Suzanne Montes was a San Francisco Fire Department firefighter in the downtown San Francisco firehouse. She was subjected to a series of disparaging comments, harassment and was ostracized within the firehouse.? She filed a complaint and ultimately filed a lawsuit in Federal court to put an end to the harassment. In June of 2018, that lawsuit was settled.?

After attorney fees and costs, her net settlement was $382,797.70 in a lump sum. Her CPA advised her that she did not have to report the $382,000 as it was a settlement. Unsurprisingly, the IRS filed a deficiency notice for unpaid tax on her settlement as based on the complaint. Her damages were for lost compensation, emotional distress, embarrassment, and humiliation. Ms. Montes sought compensatory damages, including future wages, employee benefits, emotional distress, damage to her reputation, and humiliation. There were no allegations of physical injury or physical illness.?

The case was heard in Tax Court recently (Montes v. Comm’r, 2023 WL 4316893). As expected, the court sided with the IRS, finding that there was no exclusion from income under Section 104(a)(2) of the Internal Revenue Code for her employment harassment settlement.? Settlement proceeds are only excludable under Section 104(a)(2) if the settlement is paid “on account of personal physical injuries or physical sickness.” Further, there must be a direct causal link between the damages and the physical injuries sustained.??

Employment settlements have been considered taxable since 1996

What is most surprising is the plaintiff was advised by her CPA that this settlement was tax exempt.? Section 104(a)(2) has required there be a physical injury or physical sickness for exclusion from income since 1996.? Even more surprising, this case went to Tax Court when it was clear from the outset there was no chance the court would find this excludable based on the plain reading of the statute case law and published guidance on Section 104(a)(2).

The end result was a lump sum subjected to higher federal and state income taxes (both the federal and California tax regimes are marginal, e.g., the more you receive in a taxable settlement, the higher your tax rate), interest penalties and the expense of going to Tax Court.? It is likely she has little remaining to show for her recovery.

Instead of fighting a losing battle in Tax Court, structure the settlement for a better result to provide for tax deferred growth.

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