What. A. Year.
When tax geeks arose from their slumber on January 1, 2018, we were greeted by a strange and unfamiliar world. Gone were personal exemptions, Section 199, and 50% bonus depreciation. In their place were a doubled standard deduction, Section 199A, and 100% bonus depreciation. These changes, in addition to countless others, were the end result of a whirlwind legislative process that overhauled our beloved Internal Revenue Code in a mere seven weeks, an act of Congressional hubris that tax professionals will rue for years to come.
As a result of this sweeping new legislation, ever since the calendar turned to 2018, all of our attention has been focused on getting up to speed on the new law. But while we've been up to the strained waistline of our pleated Dockers in Opportunity Zones and interest limitations, the century worth of tax law that existed prior to the Tax Cuts and Jobs Act has been completely ignored. Thousands of provisions survived the recent round of reform, and throughout 2018, many of those provisions have found their way into the Tax Court, where disputes between taxpayers and the IRS have ended in all-important judicial precedent.
But anyone who claims to have kept up with the Tax Court in 2018 is flat-out lying. Save for the occasional Wesley Snipes appearance, most of the cases decided by the court in 2018 have gone largely unnoticed, lost to the piles of proposed regulations that have been published on the new law.
And that, quite frankly, is unacceptable. We can't be like Homer, who once lamented that every time he learned something new, it pushed some old stuff out of his brain. We've got to do it all: get a grasp on the new law, while continuing to master the old. After all, Judge Holmes ain't offering up that word play for no one to read it.
So let's do this. Over the next twelve weeks, lets dissect one Tax Court case from each month of 2018. Keep in mind, these cases are not necessarily the most important decisions of each month, but rather the ones that I believe to be most useful to your humble workaday tax pro. If you disagree, write your own damn list.
For January's case, we covered Conner v. Commissioner, T.C. Memo 2018-6, a case addressing whether the sale of real estate generated ordinary income or capital gain.
For February, check out Meruelo v. Commissioner, TC Memo 2018-16, in which we discussed the many ways shareholders in an S corporation screw up trying to obtain "debt basis."
For March, we went through Simonsen v. Commissioner, 150 T.C. 8, and discovered that the tax treatment of short sales and foreclosures is anything but straightforward.
In April, we looked at Povolny Group, Inc. v. Commissioner, T.C. Memo 2018-37, and discovered that sometimes a loan isn't a loan.
For May, we beat up Barker v. Commissioner, T.C. Memo 2018-67.
In June, it was Alterman v. Commissioner, TC Memo 2018-83, which took a look at the tax treatment of marijuana facilities.
For July, we covered Martin v. Commissioner, T.C. Memo 2019-109, and learned who qualifies as a real estate professional, or to put it more accurately, who doesn't.
It's time to move on to August and Lakner v. Commissioner, T.C. Memo 2018-127, a case that will allow us to cover one of the more interesting -- and nuanced -- areas of the Code: Section 104 and the tax treatment of legal settlements and judgments.
What Makes It Special
The IRS is in the business of taxing accessions to wealth. In other words, if you wake up one morning richer than the day before, Uncle Sam wants his cut. That's why Section 61 provides the general rule that gross income "means all income from whatever source derived." So unless some specific Code section allows you to exclude an accession to wealth from your income, you've got to pay tax on it.
Section 104 is one such section. It provides an exclusion from gross income for “the amount of any 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”. The flush language of Section 104(a) provides that emotional distress shall not be treated as a physical injury or physical sickness.
But what is personal injury or physical sickness, and how do we differentiate those things from emotional distress? For example: what is an eating disorder? Is it an emotional issue, or a physical ailment? I have no idea, and would not want to be the one charged with making the determination.
With an area so grey, you might think that Section 104 would wind up in the Tax Court a lot. And you'd be right. Let's take a look at a decision from August that illustrates how the IRS and the Tax Court approach such a tricky area.
Facts In Lakner
George Lakner had a long career in the U.S. Army, during which he was stationed at various military installations in the U.S. and overseas. From 1999-2001, Lakner was employed by the VA Medical Center. During that time, he raised concerns that veterans with mental health problems were not receiving adequate care. In 2001, he was terminated from the VA.
In 2002, Lakner filed a Complaint of Employment Discrimination, alleging that he had been the victim of discrimination on the basis of religion, national origin, age and/or disability. In the alternative, he alleged that he had been fired for pointing out the VA's lapse in care.
In 2003, Lakner was deployed to Bosnia, where he was severely injured by a roadside bomb. While recovering, he was shipped to Kosovo, where he alleged he was confined for several months in military installations because the Army believed his having been terminated by the VA rendered his continued military service unlawful.
In 2010, a hearing was held, and Lakner testified that he had filed his complaint because he believed the VA had discriminated against him for being Jewish. Soon after, he was awarded a settlement of $328,000, representing pecuniary and nonpecuniary damages, attorney's fees, and accrued annual leave.
Lakner did not include the settlement amount on his 2010 tax return, taking the position that it was tax-free under Section 104, and would later argue that at least part of the payment was attributable to the injury he suffered in Bosnia. The IRS adjusted the return, arguing that the $328,000 settlement payment represented income under Section 61, and was not paid on account of physical injury or personal harm. Let's take a deeper look at Section 104 and figure out who was right.
Section 104, In General
If you sue somebody and either 1) win the suit, or 2) negotiate a settlement, your award is fully taxable under Section 61. As we previously established, however, there is an exception under Section 104(a), which provides that income does not include any damages (other than punitive damages) received on account of “personal physical injuries of physical sickness.”
As mentioned earlier, the Code makes clear that for these purposes, “emotional distress” is not treated as a physical injury or physical sickness. Making matters worse, the legislative history to Section 104 clarifies that physical symptoms arising from emotional distress–like insomnia, headaches, or stomach disorders–are also not considered personal injuries or physical sickness. Judicial precedent further clarifies that depression and anxiety are non-physical injuries, a pill that’s rather bitter to swallow if you’ve ever suffered from either. This means that if the genesis of your legal claim is emotional distress, than the full amount of compensation -- even if meant to make you whole for resulting physical symptoms -- is taxable. On the other hand, if the genesis of the claim is a physical injury, than the full amount of the payment -- other than punitive damages -- will be excludable under Section 104, even if part of the payment is meant to compensate you for emotional distress arising from the physical injury.
Thus, when determining whether a taxpayer's award or settlement payment is excludable under Section 104, you've got to get to the bottom of the original claim: what caused the taxpayer to sue in the first place? If it was an emotional injury, any award is taxable. If it was a physical injury, provided the award or settlement agreement supports that contention -- you have a tax-free payment on your hands.
In practice, however, this can often be confusing. For example, as we learned a few years ago in Barbato, the genesis of the injury may be different than the genesis of the claim.
Barbato
Debra Barbato worked for the U.S. Postal Service. In 1991, she was in a car accident while on the job, and injured her neck.
Due to the resulting physical limitations, Barbato took a different role at the USPS; one that did not require her to carry mail, but rather to stay at the station, answer calls, help at the windows, and deal with customers.
A new office manager was hired in 2004, however, and things quickly soured for Barbato. She was forced to return to carrying mail, which only worsened her neck pain. In addition, Barbato alleged that the new manager made work life tough for her by scrutinizing her work more closely than other carrier and retaliating against her when she requested medical accommodations.
As a result of the hostile work environment, Barbato began to experience severe stress and emotional difficulties to go along with her physical pain.
Frustrated, Barbato filed suit against the USPS for discriminating against her because of her prior neck injury. In 2011, Barbato won her suit, and was awarded $70,000. In the decision, the judge stated that "Barbato suffered from depression, anxiety, sleep problems, and post-traumatic stress disorder, and that the conditions were either caused by and/or exacerbated by the actions which were found to be discriminatory."
Most importantly from a tax perspective, the judge also found that Barbato's physical pain was not caused by USPS's discriminatory actions, but rather from the previous car accident.
In the year of receipt of the $70,000 payment, Barbato did not report the income on her tax return, arguing that it was excludable under Section 104. Barbato believed that while the payment was made as an award from a suit claiming emotional distress, the discrimination that was the center of the suit would have never arisen had she not suffered a previous physical injury. Thus, the ultimate genesis of her claim was a physical injury, which permitted the payment to be excluded under Section 104.
The IRS, however, had other ideas. The Service argued that the payment was made "on account of" emotional distress, not physical injury. The Tax Court agreed, concluding that even though the original incident that led to the discrimination was a physical injury, the reality was that the motivation behind Barbato's legal claim was emotional distress. Thus, while the genesis of the injury may have been physical, the genesis of the claim that led to the award was emotional distress. As a result, the $70,000 represented taxable income.
Barbato does a great job of illustrating the all-important "genesis of the claim" principle as it applies to Section 104. But how do courts make the distinction between a physical or emotional injury? Let's take a look at two other fairly recent cases, in which we learn that neither anxiety nor depression make the cut as "physical" ailments.
Smith and Blackwood
If you've ever experienced an anxiety attack, you know that it sure feels like your body is experiencing a physical trauma. The night my first kid was born, shortly after my wife got her epidural there was a lull in the labor and she fell asleep for a few hours. I fell asleep as well, and when we both woke up, it was GO TIME. There was something about going from zero to sixty that was too much for my delicate nervous system to handle, and I had a full-blown anxiety attack. I started to sweat, my chest seized up, and I lost all semblance of balance. When the nurse came back in the room, despite the fact that my wife was trying to push out a seven pound tax exemption, the nurse's immediate concern was whether I was okay.
The attack eventually passed, but the chest pain stuck around for days. In fact, before we left the hospital, the nurses got so tired of my complaining about the uncomfortable feeling that they ordered an EKG. What can I say, I'm all man.
The EKG was fine, but I had learned a harsh lesson about what anxiety can do the body, and the myriad of physical symptoms in which it can manifest.
Which makes it all the more difficult to accept that the IRS doesn't believe than anxiety is a physical malady, but all the proof you need that this is the case can be found in f Smith v. Commissioner, T.C. Summary Opinion 2014-93, settled in 2014.
In Smith, the taxpayer was a waiter at a seafood restaurant who was diagnosed with attention deficit disorder and major depressive disorder. As part of his treatment, he was prescribed stimulant medications. Being a slight fellow, his doctor was concerned that he would become dangerously underweight while taking the medication unless he was able to eat constantly. To accommodate this need, for a brief period the taxpayer's employer allowed him to break from the standard rules for on-shift dining and eat whenever he felt the need. The employer quickly backtracked, however, and began greatly limiting the taxpayer's flexibility to eat while working.
This didn't work out well for either party, and soon after, the taxpayer was fired. He quickly filed suit against his former employer, alleging that the employer discriminated against him because of his disability, and sought damages for the emotional distress, anxiety, and depression caused by his sacking.
The taxpayer eventually settled for $35,000. The first $5,000 of the settlement was earmarked as lost wages -- which is always taxable as compensation and included on a W-2--but the remaining $30,000 was described in the settlement agreement as being made for "pain and suffering and emotional distress."
The taxpayer excluded the $30,000 of settlement proceeds from his income under the belief that "pain and suffering" was synonymous with personal injury or physical sickness, and was thus excludable under Section 104.
The IRS disagreed, arguing that the $30,000 was paid to compensate the taxpayer for the depression and anxiety he suffered after being terminated, and thus was not made on account of personal injury or physical sickness.
In siding with the IRS, the Tax Court began where it begins every Section 104 analysis: at the origin of the claim. In the immediate case, the suit alleged that the taxpayer suffered "severe emotional distress, anxiety, and depression" after being terminated. Harsh as it may seem, as we discussed above, these conditions are not treated as personal injuries under the meaning of Section 104. As a result, no portion of the settlement payment was made to compensate the taxpayer for personal injury or physical harm, and the entire $35,000 was taxable under Section 61.
A similar decision was reached in Blackwood.
Julie Blackwood, who had long suffered from depression, was unceremoniously canned from her job; the details of the firing are unimportant. After her termination, Blackwood’s depression relapsed, causing her to suffer symptoms such as insomnia, sleeping too much, migraines, nausea, vomiting, weight gain, acne, and pain in her back, shoulder and neck. Blackwood sued her former employer, and was eventually awarded a $100,000 settlement. She was issued a Form 1099-MISC, but on the advice of counsel excluded the $100,000 from her tax return as a nontaxable payment pursuant to Section 104.
Blackwood argued that the exacerbation of her depression symptoms as a result of her termination was a physical injury or physical sickness. The IRS viewed it differently; arguing that the depression symptoms Blackwood suffered were properly classified as emotional distress under the flush language of Section 104(a).
The Tax Court ultimately sided with the IRS, agreeing that while Blackwood’s depression manifested itself in physical symptom, the root cause of the litigation against her former employer was not personal injury or physical harm, but rather emotional distress. A review of the congressional reports led the court to its decision:
The legislative history of section 104(a) states it “is intended that the term emotional distress includes symptoms (e.g., insomnia, headaches, stomach disorders) which may result from such emotional distress.” Congress’ listing of physical symptoms of emotional distress is evidence of Congress’ intent to establish that not every physical symptom will qualify as a physical injury or physical sickness under section 104(a)(2). Therefore, the fact that a taxpayer suffers physical symptoms from emotional distress does not automatically qualify the taxpayer for an exclusion from gross income under section 104(a)(2). …Petitioners did not provide evidence that petitioner’s physical symptoms of depression were severe enough to rise to the level of a physical injury or physical sickness.
Back to Lakner
As a reminder, Lakner received a settlement after suing his former employer for discrimination, alleging that that he had been fired either because he was Jewish, or because he had blown the whistle on what he alleged were unfair practices conducted by his employer. Lakner's complaint made no mention of a physical injury. But that's not to say his history was not without physical pain; remember, Lakner had been severely injured by a roadside bomb in Bosnia after his firing from the VA.
So here we have another case, like Barbato, with both a physical and emotional component. But unlike in Barbato, wherein the taxpayer suffered a physical injury before enduring subsequent emotional distress (and remember, she lost anyway!), in Lakner, the physical injury occurred after the taxpayer's termination. In fact, the injury had occurred after Lakner had filed his suit!
This rather unfortunate fact didn't stop Lakner from testifying that the settlement he received had "linkage" to the physical injury, arguing that his physical pain resulting from the bombing was exacerbated while confined in Kosovo, an action that was only necessary because he had been dismissed by the VA. Thus, he argued, part of the settlement was meant to remedy the physical pain that was made worse by conditions resulting from his firing.
But as we've learned by now, repercussions occurring after a legal claim are irrelevant. All that matters is this: what harm did the taxpayer allege in the original claim, and what was the first harm being alleged? In this case, the Tax Court's decision was a simple one: the claim made no mention of a physical injury, so the settlement proceeds could not possibly have intended to compensate Lakner for personal harm. As a result, he was not permitted to exclude the proceeds under Section 104.
Summary
By its very nature, Section 104 will forever be a frequent guest in the Tax Court. The blurred line between personal injury and emotional distress are extremely difficult to decipher, and the stakes are high with regard to taxable income.
As an aside, if you would like to take inl perhaps the most ingenious (albeit unsuccessful) Section 104 claim, I highly recommend you give this a read.
