The court, however, found that 10% of the settlement award was excludable from gross income under section 104(a)(2) and regulations.
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The taxpayer initiated an employment discrimination action against her employer under California law. She claimed that she was entitled to compensatory damages for, among other things, physical injuries and illness.
A California state court dismissed all but one claim alleged in the taxpayer’s discrimination suit, and eventually, the taxpayer’s attorney concluded that she would not be able to recover from the employer on the basis of the one remaining discrimination claim.
However, because it was discovered that the taxpayer was eligible for workers’ compensation benefits under California law, the taxpayer filed a workers’ compensation claim.
Eventually, the taxpayer and her employer reached a settlement. The taxpayer released the employer from all claims “including, but not limited to, claims asserted in” the original discrimination law suit. The settlement agreement did not specifically mention the possible workers’ compensation claims.
Neither the taxpayer nor her employer submitted the settlement agreement to the California Workers’ Compensation Appeals Board for approval (as required under California law). Based on the agreement, the taxpayer claimed that only part of the settlement award was attributable to lost wages and was taxable, and that other portions were for the taxpayer’s personal physical injuries and physical sickness and excludable.
Tax Court’s opinion
The Tax Court found that the settlement agreement was ambiguous as to whether it was made to settle the taxpayer’s discrimination claims, her workers’ compensation claims, or both. Specifically, the court observed that California’s workers’ compensation laws has a strict regime for parties to validly settle a worker compensation claim and that the board must approve any release of or agreement to compromise an employer’s liability for workers’ compensation benefits before the agreement or release can be valid.
Because the taxpayer did not follow this process, the court concluded:
- None of the settlement payment received by the taxpayer was excludable from her gross income under section 104(a)(1) because she had failed to obtain the requisite approval from the state board, as required under California worker compensation law.
- However, 10% of the settlement award was excludable from gross income under section 104(a)(2) and the related regulations—i.e., the provisions that exclude damages from income as long as recovery is for personal physical injuries or physical sickness (1) even if recovery is under a statute that does not provide for a broad range of remedies and (2) even if the injury is not defined as a tort under state or common law.
- The portion of the settlement award allocated to attorney’s fees and court costs was deductible under section 62(a)(20).