Kathleen S. Simpson & George T. Simpson v. Commissioner , 141 T.C. No. 10 ( 2013 )

141 T.C. No. 10UNITED STATES TAX COURT
KATHLEEN S. SIMPSON AND GEORGE T. SIMPSON, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 26619-11. Filed October 28, 2013.
P-W sued E, her employer, for employment discrimination
under California’s Fair Employment and Housing Act (FEHA),
claiming, among other things, that she was entitled to compensatory
damages for, among other things, physical injuries. After the State
court dismissed all but one claim alleged in the suit, P-W’s attorney
concluded that P-W would not be able to extract a settlement from E
on the basis of the one remaining FEHA claim. P-W’s attorney
learned, however, that P-W was eligible for workers’ compensation
benefits under California’s workers’ compensation laws. On that
basis alone, P-W and E engaged in settlement discussions and
eventually entered into a settlement agreement by which P-W
released E from “each and every claim” she might have against E,
“including, but not limited to, claims asserted in” the FEHA lawsuit;
the settlement agreement did not specifically mention P-W’s possible
workers’ compensation claims. Neither P-W nor E submitted the
settlement agreement to the California Workers’ Compensation
Appeals Board (WCAB) for the approval required under California’s
workers’ compensation laws. Ten percent of the settlement award
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was attributable to P-W’s personal physical injuries and physical
sickness.
Held: None of the settlement payment P-W received is
excludable from Ps’ gross income under I.R.C. sec. 104(a)(1) because
P-W did not obtain the requisite approval from the WCAB required
by the State’s workers’ compensation laws.
Held, further, 10% of P-W’s settlement award is excludable
from Ps’ gross income under I.R.C. sec. 104(a)(2) and the newly
amended regulations under that section, which exclude damages from
income as long as recovery is for personal physical injuries or
physical sickness even if recovery is under a statute that does not
provide for a broad range of remedies and even if the injury is not
defined as a tort under State or common law.
Held, further, the portion of the settlement award allocated to
attorney’s fees and court costs is deductible under I.R.C. sec.
62(a)(20).
Elizabeth L. Riles and David C. Anton, for petitioners.
Matthew D. Carlson, for respondent.
LARO, Judge: Respondent determined a Federal income tax deficiency of
$73,407 for 2009 and an accuracy-related penalty under section 6662(a) of
$14,681.1 Petitioners, while residing in California, timely petitioned this Court to
1
Unless otherwise indicated, section references are to the Internal Revenue
Code (Code) in effect for the year in issue, and Rule references are to the Tax
(continued...)
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redetermine respondent’s determination. Following respondent’s concession that
petitioners are not liable for the accuracy-related penalty, we decide: (1) whether
any portion of $250,0002 petitioners received in 2009 in settlement of a dispute
with Sears, Roebuck & Co. (Sears) is excludable from their gross income under
section 104(a)(1) or (2). We hold it is not excludable under section 104(a)(1) but
excludable under section 104(a)(2) to the extent set out in this Opinion; (2)
whether section 62(a)(20) allows petitioners to deduct $152,000 of attorney’s fees
and court costs as an above-the-line deduction. We hold it does.
FINDINGS OF FACT
The parties filed with the Court a stipulation of facts and related exhibits.
Those facts and exhibits are incorporated in this Opinion by this reference. We
find the facts accordingly.
Ms. Simpson started working for Sears in 1972 and performed various jobs
such as data retrieval, project management, compensation management, and
human resources. In the latter part of the 1990s Ms. Simpson began taking on
1
(...continued)
Court Rules of Practice and Procedure.
2
The actual settlement amount was $262,500, which included $12,500 for
lost wages and benefits. Petitioners included the $12,500 in their gross income for
2009, and the $12,500 is not at issue.
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more responsibilities and was promoted to manager of a small store in Prescott,
Arizona, a position she held for about 18 months. Subsequently, she was
promoted to a district-level position as a merchandise manager assisting the stores
to purchase and assort hardware and lawn and garden merchandise. Two years
after that, in October 2000 Ms. Simpson was transferred to manage another Sears
store in Fairfield, California.
The Fairfield store was much larger than the Prescott store, e.g., the
Fairfield store had three times the sales volume and a fuller assortment of
merchandise than the Prescott store. In addition, Ms. Simpson knew that the
Fairfield store was a problem store in that the prior store manager and prior
numerous management and staff were terminated and almost the entire staff had
less than one year of management experience.
Because of the problems at the store and the need to provide relief to the
staff, Ms. Simpson had to work long hours, sometimes 50 to 60 hours a week in
addition to her three-hour daily commute. In addition, Ms. Simpson had to fill in
for some of her sales managers and engage in strenuous physical activities such as
receiving, unpacking, and stocking merchandise, moving garments from racks, and
ripping plastic. The physical exertion resulted in injuries to her shoulders, to her
left knee, and to her neck. Ms. Simpson became exhausted, lost 25 pounds, and
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considered committing suicide. She sought counselors and physicians for
treatment and was ultimately diagnosed with clinical depression, irritable bowel
syndrome, and fibromyalgia.
In March 2002 Ms. Simpson approached Sears’ district human resources
manager, Nancy Mallory, and informed her of the diagnoses and the physical
problems Ms. Simpson was experiencing. Ms. Simpson also told Ms. Mallory that
her sickness was work related and that on the advice of her doctor, she wanted to
transfer to another position. Ms. Simpson fully expected Ms. Mallory to refer the
issue to management and to provide a reasonable solution.
Ms. Mallory never informed anyone within Sears of the information Ms.
Simpson provided in the March 2002 meeting. Nor did Ms. Mallory tell anyone
that Ms. Simpson had requested a transfer because of her work-related clinical
depression and physical illness.
After not hearing back from Ms. Mallory about her complaints, Ms.
Simpson spoke to Sears’ district manager in June of the same year and advised
him of the diagnoses. Ms. Simpson also explained to the district manager that her
clinical depression and physical sickness were work related and requested that she
be transferred to another position. Sears never transferred Ms. Simpson to another
position. In August 2002, Sears terminated Ms. Simpson’s employment. No one
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at Sears ever provided Ms. Simpson with a California Workers’ Compensation
Claim Form or with information about filing such a claim.
Ms. Simpson continued to suffer from depression and work-related physical
injuries after her termination, and she remained unemployed for one year. She was
then able to secure a retail position with a home improvement retail chain where
she had to quit after a month because of the limitations imposed by her mental and
physical problems. She eventually secured employment with the State of
California in a human resources position and remains employed there today.
After termination of her employment with Sears, Ms. Simpson retained
David Anton to file a lawsuit against Sears under California’s Fair Employment
and Housing Act (FEHA). The first amended complaint alleged in the first cause
of action a claim for employment discrimination on the basis of gender, age, and
harassment in violation of Cal. Gov’t Code sec. 12940(a), (j) and (k) (West 2011).
The first cause of action claimed that Ms. Simpson experienced lost wages, lost
employment benefits, emotional distress, and mental pain and suffering. The
second cause of action alleged retaliation in employment in violation of Cal. Gov’t
Code sec. 12940(h) and claimed Ms. Simpson experienced lost wages, lost
employment benefits, emotional distress, and mental pain and suffering resulting
in physical injury.
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The third cause of action alleged two claims. One claim under Cal. Gov’t
Code sec. 12940(m) alleged that Sears failed to provide a reasonable
accommodation of a job transfer for Ms. Simpson after learning of her work-
related mental disability. The other claim under Cal. Gov’t Code sec. 12940(n)
alleged that Sears failed to engage in an interactive process with Ms. Simpson
when it learned that Ms. Simpson had a work-related mental disability, was
receiving treatment, and had asked to be transferred to another position because of
the disability. The third cause of action alleged that Ms. Simpson suffered lost
wages and employment benefits, emotional distress, mental pain and suffering,
and physical injury. Ms. Simpson sought economic damages (e.g., back and future
pay), noneconomic damages (e.g., compensatory damages for emotional distress),
punitive damages, interest, attorney’s fees and costs, and appropriate injunctive
relief.
Sears filed a summary judgment and adjudication motion that was heard in
May 2009. The State court granted Sears’ motion on the first and second causes
of action. As to the third cause of action, the State court granted Sears’ motion on
the claim under Cal. Gov’t Code sec. 12940(m) but allowed the claim under Cal.
Gov’t Code sec. 12940(n) to go forward. In reaching its decisions, the State court
found Ms. Simpson could not prove that Sears had fired her for reasons other than
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poor job performance or that her transfer to another position within Sears would
have been a reasonable accommodation.
Ms. Simpson and Sears later engaged in settlement discussions. Mr. Anton
concluded that as a result of the State court’s findings, Ms. Simpson would not be
able to claim damages for lost wages or emotional distress on the basis of Sears’
failure to engage in an interactive process required under Cal. Gov’t Code sec.
12940(n).3 However, Mr. Anton’s research led him to conclude that Sears’ failure
to give Ms. Simpson a California Workers’ Compensation Claim Form and a
notice of potential eligibility for benefits that were required under California’s
workers’ compensation laws, see Cal. Lab. Code secs. 5400-5413 (West 2011),
violated Sears’ legal obligations under those laws.
Mr. Anton relayed his conclusion to Sears’ counsel and asserted that Ms.
Simpson would have been entitled to certain workers’ compensation benefits,
including benefits for temporary disabilities and permanent disabilities resulting
from work-related injuries, if she had filed such a claim.4 Mr. Anton believed
3
We do not express any opinion as to whether Mr. Anton’s assessment was
supported by the facts and the law underlying Ms. Simpson’s FEHA claims.
4
Mr. Anton had initially argued for vocational retraining benefits in addition
to temporary disability and permanent disability benefits but did not include these
benefits in the final settlement value.
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these workers’ compensation benefits were the only damages available to Ms.
Simpson, and he formulated a settlement proposal on that basis alone. He
hypothesized the weekly temporary disability benefits that Ms. Simpson would be
entitled to receive under California’s workers’ compensation laws (approximately
$500) as well as an additional 25% penalty that could be imposed on Sears for
failing to advise Ms. Simpson of potential workers’ compensation eligibility and
benefits, as the amount of temporary disability benefits owing to Ms. Simpson.
Mr. Anton referenced the Schedule for Rating Permanent Disabilities issued under
California workers’ compensation laws as the amount of permanent disability
award Ms. Simpson would be entitled to receive. These two amounts formed the
sole basis of a settlement agreement that Ms. Simpson and Sears later entered into
in June 2009 as to Ms. Simpson’s lawsuit against Sears.
In exchange for the release, Sears agreed to pay under the settlement
agreement $12,500 to Ms. Simpson as to her claim for lost wages and employment
benefits; $98,000 to Ms. Simpson as to her claims for “emotional distress, physical
and mental disability”; and $152,000 to Mr. Anton for attorney’s fees and court
costs. Mr. Anton understood that the $98,000 was intended to compromise Ms.
Simpson’s claim for workers’ compensation benefits for “emotional distress and
physical and mental disabilities” that she suffered from work-related injuries, i.e.,
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clinical depression, irritable bowel syndrome, and fibromyalgia, while working for
Sears, and he attributed 10% to 20% of the $98,000 to the work-related physical
illness and disabilities Ms. Simpson suffered. The settlement agreement provides
that California laws govern the contract and states that
SIMPSON expressly waives, releases and forever discharges the
Company from each and every claim, whether known or unknown
that SIMPSON has, had, or might have, arising out of, or related to,
any events occurring up to the date this Agreement is fully executed,
including, but not limited to, claims asserted in * * * [the FEHA
lawsuit]. SIMPSON also promises that she will not seek any further
compensation for any other claimed damages, costs or attorneys’ fees
in connection with the matters encompassed in this Agreement.
[Emphasis added.]
Ms. Simpson never filed a workers’ compensation claim, and Sears and Ms.
Simpson never submitted the settlement agreement to the California Workers’
Compensation Appeals Board (WCAB) for the approval required under Cal. Lab.
Code sec. 5001 (West 2011). Mr. Anton was not aware of the approval
requirement.
Petitioners timely filed their 2009 Federal income tax return with the
assistance of H&R Block. The 2009 return reported as income the $12,500
payment that Sears made to Ms. Simpson for lost wages and employment benefits.
The 2009 return did not report anything else from the settlement. Petitioners
attached to the 2009 return a letter dated March 18, 2010, from Mr. Anton,
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explaining the nature of the $250,000 proceeds reported in petitioners’ Form
1099-MISC, Miscellaneous Income, received from Sears and why petitioners were
not reporting any portion of it. The letter stated the following:
The listed amount includes amounts that were paid to my office for
attorney’s fees and costs, which my office is reporting as income, in
the amount of $113,985.60, for a net to Ms. Simpson from the
$250,000.00 of $136,014.40. Due to the nature of the claim that was
settled, although I am not Ms. Simpson’s tax adviser, I understand
that the settlement proceeds should not be considered taxable.
* * * * * * *
* * * [On the summary judgment and adjudication motion, the] Judge
found that there was evidence that the Human Resources Manager
failed to take any action or interact with anyone at the company as a
result of the information that Ms. Simpson was sick and disabled as a
result, and failed to advise the direct managers over Ms. Simpson of
the illness and resulting disability. The Human Resources Manager
should have considered placing Ms. Simpson on Workers’
Compensation disability leave, or on Short Term Disability leave, but
did not do so.
The settlement was entirely based upon the claim that Ms.
Simpson became ill due to work, became disabled due to the severity
of that illness, and Ms. Simpson should have been accommodated by
being provided Workers’ Compensation or Short Term Disability
Leave, but was not. It is our understanding that a lawsuit settlement
based on illness and disability from work are non-taxable settlement
proceeds to the injured taxpayer.
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On April 25, 2011, respondent issued to petitioners a notice of deficiency in
which he determined that petitioners failed to report the $250,000 settlement
proceeds as income. In response, petitioners filed the instant petition.
OPINION
Gross income includes all income from whatever source derived, sec. 61(a);
Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 429 (1955), unless
specifically excluded. Under section 104(a)(1), “amounts received under
workmen’s compensation acts” to compensate for personal injuries or sickness are
excluded from income. Section 104(a)(2) excludes from income the amount of
any damages (other than punitive damages) received (by suit or agreement) on
account of personal physical injuries or physical sickness.
Adjusted gross income means gross income less certain enumerated
deductions. Sec. 62(a). One of these deductions is a deduction for attorney’s fees
and court costs paid by, or on behalf of, a taxpayer in connection with any action
involving a claim of unlawful discrimination. Sec. 62(a)(20).
Petitioners argue primarily that the entire settlement amount in issue,
$250,000, is excludable from gross income under section 104(a)(1) as an amount
received under California’s workers’ compensation laws. Petitioners argue
alternatively that (1) up to 20% of the $98,000 settlement figure allocated to
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“emotional distress and physical and mental disabilities” is excludable from gross
income under section 104(a)(2) as an amount received on account of personal
physical injuries and physical sickness and that (2) petitioners are entitled to
deduct under section 62(a)(20) $152,000 allocated to attorney’s fees and court
costs in connection with Ms. Simpson’s FEHA action involving unlawful
discrimination claims.
I. Burden of proof
The Commissioner’s determinations in a notice of deficiency are generally
presumed correct, and a taxpayer bears the burden of proving those determinations
are erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). It is
well established that statutory exclusions, such as those provided in section 104,
are to be narrowly construed, see Commissioner v. Schleier, 515 U.S. 323, 328
(1995), and that taxpayers generally bear the burden of proving that they fall
squarely within the requirements for any exclusion from gross income, Forste v.
Commissioner, T.C. Memo. 2003-103, 85 T.C.M. (CCH) 1146, 1151 (2003).
At trial, petitioners conceded that the burden of proof falls on them. In their
posttrial brief, however, petitioners for the first time request the Court to shift the
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burden of proof to respondent under section 7491(a).5 We find that petitioners
conceded this issue at trial and that their request made in the posttrial brief to shift
the burden of proof to respondent prejudices respondent and is untimely. See
Dunne v. Commissioner, T.C. Memo. 2008-63, 95 T.C.M. (CCH) 1236, 1240
(2008); Smith v. Commissioner, T.C. Memo. 2007-368, 94 T.C.M. (CCH) 574,
581 (2007), aff’d, 364 Fed. Appx. 317 (9th Cir. 2009); Deihl v. Commissioner,
T.C. Memo. 2005-287, 90 T.C.M. (CCH) 579, 584 (2005). At a minimum,
respondent has not been afforded an opportunity to test petitioners’ allegations,
either by cross-examination or by producing evidence, that petitioners have
complied with the substantiation and recordkeeping requirements under section
7491(a)(2).
II. Exclusion from income
Gross income does not include “amounts received under workmen’s
compensation acts as compensation for personal injuries or sickness” as well as
“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”. Sec. 104(a)(1) and (2). When
5
Neither the petition nor petitioners’ pretrial brief asked the Court to shift
the burden of proof to respondent under sec. 7491(a).
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a taxpayer receives a payment under a settlement agreement, as is the case here,
the nature of the claim that was the actual basis for settlement guides our
determination of whether such payments are excludable from income. See United
States v. Burke, 504 U.S. 229, 237 (1992). Whether a settlement is achieved
through a judgment or by a compromise agreement, the question to be asked is “In
lieu of what were the damages awarded?” Fono v. Commissioner, 79 T.C. 680,
692 (1982), aff’d without published opinion, 749 F.2d 37 (9th Cir. 1984).6
A. Sears’ intent
What Ms. Simpson and Sears intended to compromise through the
settlement agreement is a question of fact, see Bagley v. Commissioner, 105 T.C.
396, 406 (1995), aff’d, 121 F.3d 393 (8th Cir. 1997), determined by reference to
the express language of the agreement, Knuckles v. Commissioner, 349 F.2d 610,
613 (10th Cir. 1965), aff’g T.C. Memo. 1964-33. If we cannot find evidence of
the parties’ express intent in the settlement agreement specifying the purpose of
the compensation, we look to the payor’s intent. Rivera v. Baker West, Inc., 430
6
United States v. Burke, 504 U.S. 229 (1992), and Fono v. Commissioner,
79 T.C. 680 (1982), aff’d without published opinion, 749 F.2d 37 (9th Cir. 1984),
deal with agreements to settle personal injuries claims in the context of sec.
104(a)(2). While sec. 104(a)(1) does not explicitly mention settlement, we find it
helpful here to look to cases like Burke and Fono to determine whether a
settlement for a workers’ compensation claim sanctioned by a State’s workers’
compensation laws can be excludable under section 104(a)(1).
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F.3d 1253, 1257 (9th Cir. 2005); Knuckles v. Commissioner, 349 F.2d at 613; see
also Fono v. Commissioner, 79 T.C. at 696 (stating that payee’s belief as to
reasons for payment is relevant evidence although ultimate inquiry is into payor’s
reasons for payment); cf. Commissioner v. Duberstein, 363 U.S. 278, 285-286
(1960) (stating that transferor’s intention is most crucial consideration in
determining whether payment is gift). Under California law, which governs the
interpretation of Ms. Simpson’s settlement agreement with Sears, we must
consider all credible evidence to determine whether the language of the agreement
is fairly susceptible of more than one interpretation, and if it is, we must consider
extrinsic evidence relevant to prove which one of these meanings reflects the
intent of the contracting parties. Pac. Gas & Elec. Co. v. G.W. Thomas Drayage &
Rigging Co., 69 Cal. 2d 33, 39-40 (1968).
The settlement agreement is ambiguous as to whether it was made to settle
Ms. Simpson’s FEHA claims, her workers’ compensation claims, or both. The
preamble of the agreement broadly states that Sears and Ms. Simpson desired to
resolve all claims Ms. Simpson raised or could have raised in the FEHA lawsuit as
well as “any other matters involving SIMPSON’s former employment relationship
with * * * [Sears]”, but it falls short of expressly including Ms. Simpson’s
workers’ compensation claim. Indeed, the settlement agreement includes multiple
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references to the FEHA lawsuit but does not mention Ms. Simpson’s potential
workers’ compensation claims at all. But we also accept Mr. Anton’s credible
testimony that he had advised Sears’ counsel that his client was eligible to make
such claims. In the light of this fact, the broad and inclusive general release in the
settlement agreement ought to place Ms. Simpson’s workers’ compensation claims
under the settlement agreement although the agreement itself does not state so
expressly.
Ambiguity also arises where California’s workers’ compensation laws
specifically require that any compromise agreement to settle such workers’
compensation claims be submitted to the WCAB for approval, and the parties did
not do so here. From this fact one may infer that the parties, who were represented
by presumably competent counsel, did not contemplate any potential workers’
compensation claim. See Steller v. Sears, Roebuck & Co., 189 Cal. App. 4th 175,
182 (Ct. App. 2010). Because extrinsic evidence before us exposes a latent
ambiguity in Ms. Simpson’s settlement agreement with Sears, we must consider
extrinsic evidence to determine the parties’ intent. See id. at 183 (finding
ambiguity in settlement agreement and concluding on extrinsic evidence that
settlement encompassed workers’ compensation claim and disability
discrimination claim).
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We find Ms. Simpson and Mr. Anton to be generally credible. Ms. Simpson
testified that she believed the settlement agreement was made to settle her one
remaining FEHA claim (i.e., Sears’ failure to engage in an interactive process
under Cal. Gov’t Code sec. 12940(n)) and her workers’ compensation claims. Mr.
Anton testified that he saw no damage potential on the basis of the one remaining
claim in the FEHA lawsuit and concluded that he could extract a settlement from
Sears only on the basis of Ms. Simpson’s entitlement to workers’ compensation
benefits. Mr. Anton also testified credibly that the $98,000 amount was
determined by reference to the disability benefits provided under California’s
workers’ compensation laws for the “emotional distress, physical and mental
disability” that Ms. Simpson suffered while employed at Sears. He further
testified credibly that 10% to 20% of the $98,000 portion of the settlement amount
was attributable to personal physical injuries (other than emotional distress).
Viewing the entire record before us, we find that Sears and Ms. Simpson intended
to settle her workers’ compensation claims and that a portion of the settlement was
made to compensate her for her work-related personal physical injuries and
sickness.
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B. Section 104(a)(1)
The intent of the parties to a settlement of a workers’ compensation claim
does not necessarily mean that the payment is excludable under section 104(a)(1),
however.7 Section 104(a)(1) excludes from gross income amounts received by an
employee under a workers’ compensation act or under a statute in the nature of a
workers’ compensation act that provides compensation to employees for
occupational personal injuries or sickness. Sec. 1.104-1(b), Income Tax Regs. To
qualify for the exclusion, a taxpayer must show that she received her benefits
under a statute or a regulation. Rutter v. Commissioner, 760 F.2d 466, 468 (2d
Cir. 1985), aff’g T.C. Memo. 1984-525 (1984). In other words, unless payments
are made pursuant to “‘a rule of general applicability promulgated by a public
agency to govern conduct within the agency’s jurisdiction’”, a taxpayer cannot
exclude the payments from gross income under section 104(a)(1). Wallace v.
United States, 139 F.3d 1165, 1167 (7th Cir. 1998) (quoting Rutter v.
Commissioner, 760 F.2d at 468). Thus, for Ms. Simpson’s settlement payment to
be an amount “received under workmen’s compensation acts,” the settlement
agreement must comply with the statutory requirements to be valid under
7
It is conceivable that under certain statutory regime, parties may privately
settle a workers’ compensation claim pursuant to a statute without State action.
These are not the facts of this case, and we need not discuss hypotheticals.
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California’s workers’ compensation laws and not go beyond the scope of such
laws.8
California’s workers’ compensation laws set up a strict regime for parties to
validly settle a workers’ compensation claim under those laws. The laws provide
a rule of general applicability requiring that the WCAB approve any release of or
agreement to compromise an employer’s liability for workers’ compensation
benefits before the agreement or release could become valid. Cal. Lab. Code sec.
5001. The same laws also require that the parties file the signed release or
compromise agreement with the WCAB for the board to enter the award based on
the release or compromise agreement. Id. sec. 5002. Petitioners have
acknowledged that they never submitted the settlement agreement in issue to
WCAB for approval, nor did they obtain the required approval from the board.
Mr. Anton apparently was not aware of these requirements under Cal. Lab. Code
secs. 5001 and 5002.
Because the settlement agreement fails to meet the express requirement of
California’s workers’ compensation laws to obtain approval from the WCAB, any
payments received under the agreement cannot be payments received under or
8
For example, compensation received for an occupational injury or sickness
in excess of the amount provided in the applicable workers’ compensation act is
not excludable. Sec. 1.104-1(b), Income Tax Regs.
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pursuant to the State’s workers’ compensation act. The aggregate payments of
$250,000 petitioners received under the settlement agreement are merely payments
made under a private contract, cf. Rutter v. Commissioner, 760 F.2d at 468, that
has no force or effect under California’s workers’ compensation laws, see Steller,
189 Cal. App. 4th at 181-182; Raischell & Cottrell, Inc. v. Workmen’s Comp.
Appeals Bd., 249 Cal. App. 2d 991, 997 (Ct. App. 1967).
A recent California State court decision informs our conclusion. The State
court in Steller was confronted with facts very similar to those here. There, an
employee sued her employer for disability discrimination and was simultaneously
pursuing a workers’ compensation claim against her employer. Steller, 189 Cal.
App. 4th at 178. The parties entered into an agreement to settle all of the
employee’s claims that arose from the lawsuit and related to her employment; the
settlement agreement did not expressly mention the pending workers’
compensation action. Id. at 179. The trial court entered a judgment in the
disability discrimination action according to the terms of the compromise
agreement. Id. The record did not show that the parties were aware of the
approval requirement or contemplated obtaining the WCAB’s approval. Id. at
181.
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On appeal, the California Court of Appeal construed the judgment as
encompassing both the disability discrimination and workers’ compensation
claims. Id. at 180. But citing Cal. Lab. Code sec. 5001, the court stated that “‘the
effect of the section, by its clear wording, is to make every compromise invalid
until it is approved by [the WCAB].’” Id. (alteration in original) (quoting Chavez
v. Indus. Accident Comm’n, 49 Cal. 2d 701, 702 (1958)). The Court of Appeal
thus held that a compromise agreement seeking to settle both a civil action and a
related workers’ compensation claim must be deemed to have been conditioned on
the WCAB’s approval. Id. at 181. Until parties to a settlement obtain such
approval, any compromise and release of workers’ compensation liability is
invalid. Id.; see also Raischell & Cottrell, Inc., 249 Cal. App. 2d at 997.
Thus, the settlement agreement between Sears and Ms. Simpson is not a
valid agreement to settle her workers’ compensation claims because the parties
failed to obtain the requisite approval from the WCAB. Because neither Sears nor
Ms. Simpson has taken the crucial step to submit the settlement agreement for the
WCAB’s approval, any payments received under the settlement are not “amounts
received under workers’ compensation acts”. See Forste v. Commissioner, 85
T.C.M. (CCH) at 1152 n.15.
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C. Section 104(a)(2)
We now turn to petitioners’ alternative claim that 10% to 20% of the
$98,000 received under the settlement agreement is excludable under section
104(a)(2) as an amount received “on account of personal physical injuries or
physical sickness.”
1. Section 104(a)(2) regulations
The Supreme Court has held that for a recovery to be excludable under
section 104(a)(2), a taxpayer must “demonstrate that the underlying cause of
action giving rise to the recovery is ‘based upon tort or tort type rights’; * * * [in
addition], the taxpayer must show that the damages were received ‘on account of
personal injuries or sickness.’”9 Commissioner v. Schleier, 515 U.S. at 337. The
requirement that recovery be based on a tortlike action was rooted in the former
regulations, see sec. 1.104-1(c), Income Tax Regs., before amendment by T.D.
9573, 2012-12 I.R.B. 498 (former regulations), which for the first time “formally
* * * linked identification of a personal injury for purposes of §104(a)(2) to
9
In 1996 Congress amended sec. 104(a)(2) by adding the requirement that
any amount received must be on account of personal injuries that are physical or
sickness that is physical. Small Business Job Protection Act of 1996, Pub. L. No.
104-188, sec. 1605, 110 Stat. at 1838.
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traditional tort principles”.10 Burke, 504 U.S. at 234; see also T.D. 6500, 25 Fed.
Reg. 11402, 11490 (Nov. 26, 1960).
Fifteen years after Congress amended section 104(a)(2) in 1996 to state that
the section applies to personal injuries and sickness that are physical, the Secretary
amended the regulations and abandoned the “based upon tort or tort type rights”
requirement so long as recovery is for personal physical injuries or physical
sickness even if recovery is under a statute that does not provide for a broad range
of tort remedies. See sec. 1.104-(c), Income Tax Regs.11
10
The former regulations read as follows:
Section 104(a)(2) excludes from gross income the amount of any
damages received (whether by suit or agreement) on account of
personal injuries or sickness. The term ‘damages received (whether
by suit or agreement)’ means an amount received (other than
workmen’s compensation) through prosecution of a legal suit or
action based upon tort or tort type rights, or through a settlement
agreement entered into in lieu of such prosecution.
Current sec. 1.104-1(c)(3), Income Tax Regs., “applies to damages paid
pursuant to a written binding agreement, court decree, or mediation award entered
into or issued after September 13, 1995, and received after January 23, 2012.
Taxpayers also may apply these final regulations to damages paid pursuant to a
written binding agreement, court decree, or mediation award entered into or issued
after September 13, 1995, and received after August 20, 1996.”
11
The preamble of the amended regulations, T.D. 9573, 2012-12 I.R.B. 498,
states:
(continued...)
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We have said that “[s]ettlement amounts which are paid to settle workers’
compensation claims are not excludable from gross income under section
104(a)(2) * * * [because] claims for workers’ compensation do not necessarily
involve tort or tort type rights.” Forste v. Commissioner, 85 T.C.M. (CCH) at
1155 (“A worker’s compensation claim is not itself a tort or tort type cause of
action since its elements involve fixed awards and since it is based on no-fault
principles.”). Hence, absent a change in the law that applied in this case, the result
here would seem to flow from our statement in Forste.12 Such a change in law,
11
(...continued)
Before the 1996 amendment, the section 104(a)(2) exclusion was not
limited to damages for physical injuries or sickness. The tort-type
rights test was intended to distinguish damages for personal injuries
from, for example, damages for breach of contract. Since that time,
however, Commissioner v. Schleier, 515 U.S. 323 (1995), has
interpreted the statutory “on account of” test to exclude only damages
directly linked to “personal” injuries or sickness. Furthermore, under
the 1996 Act, only damages for personal physical injuries or physical
sickness are excludable. These legislative and judicial developments
have eliminated the need to base the section 104(a)(2) exclusion on
tort cause of action and remedy concepts.
12
As Mr. Anton’s testimony shows, the workers’ compensation claim that
formed the basis of Ms. Simpson’s eventual settlement with Sears provided only
the types of fixed and limited benefits that were incongruous with traditional tort
or tort type damages. Permanent disability benefits under California laws, which
underlaid a portion of the settlement amount, are intended to compensate an
injured worker for her diminished earning capacity resulting from her work-related
injuries. Gamble v. Workers’ Comp. Appeals Bd., 143 Cal. App. 4th 71, 80 (Ct.
(continued...)
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however, appears in the new regulations which have dispensed with the “based
upon tort or tort type rights” requirement outlined in Burke and its progeny.
The parties do not dispute the validity of the new regulations, and in the
setting at hand we apply them as written.13 In other words, under the applicable
regulations, even if payments under a settlement of a workers’ compensation claim
are not excludable under section 104(a)(1) because they fail to be “amounts
received under workmen’s compensation acts”, some or all of the payments may
nonetheless be excluded from gross income under section 104(a)(2) if the taxpayer
can show the portion of the workers’ compensation claim that is predicated on the
taxpayer’s personal physical injuries or physical sickness. As we elaborate below,
12
(...continued)
App. 2006). Similarly, temporary disability benefits under California laws, which
formed the remaining portion of Ms. Simpson’s settlement, seek to provide an
injured employee interim wage replacement assistance during the period she is
healing. Id. at 79-80. Thus, the remedial scheme under the California laws does
not appear to compensate an injured employee for tortlike personal injuries that
are broad in scope. But it instead appears to address narrowly and exclusively
“‘legal injuries of an economic character’”, Commissioner v. Schleier, 515 U.S. at
335 (quoting Burke, 504 U.S. at 238-239), because it aims only to restore the
injured employee to the economic position that the State has deemed she would
have occupied absent the disability or disabilities the occupational injuries have
caused.
13
The new regulations may be applied retroactively at the desire of the
taxpayer. Sec. 1.104-1(c)(3), Income Tax Regs. The new regulations are
favorable to petitioners, and we thus apply the regulations retroactively to their
benefit.
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we find that a portion of the settlement amount was to compensate Ms. Simpson
for her personal physical injuries and physical sickness.
2. Amount attributable to personal physical injuries or physical
sickness
On the basis of admissible and credible extrinsic evidence, we have found
that Sears and Ms. Simpson intended to settle her potential workers’ compensation
claims. The record has also established that she suffered physical personal injuries
and sickness forming part of the basis of her workers’ compensation claims.
Viewing the entire record, we conclude that the settlement of Ms. Simpson’s
workers’ compensation claims had elements intended to compensate those
physical personal injuries and sickness. Because the record before us “is not
susceptible of any precisely accurate determination” of the extent to which the
settlement was attributable to Ms. Simpson’s personal physical injuries and
sickness, we use our best judgment and find that 10% of the settlement payment of
$98,000 was made on account of those physical injuries and physical sickness
(other than emotional distress). See generally Eisler v. Commissioner, 59 T.C.
634, 641 (1973). As we stated before, when a precise determination cannot be
made, “the most that can be expected of us is the exercise of our best judgment
based upon the entire record.” Id. This we have endeavored to do. Accordingly,
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we conclude 10% of Ms. Simpson’s settlement payment of $98,000 is excludable
from gross income under section 104(a)(2).
III. Deduction for attorney’s fees and court costs
Because we have concluded that the settlement amount was not received
under a workers’ compensation act, we now have to decide whether $152,000 of
the settlement amount allocated to attorney’s fees and court costs is deductible
under section 62(a)(20).
Section 62(a)(20) allows an above-the-line deduction for attorney’s fees and
court costs paid by, or on behalf of, a taxpayer in connection with any action
involving an unlawful discrimination claim. See also sec. 62(e) (defining
“unlawful discrimination”). The amount of a deduction under this section cannot
exceed the amount includible in the taxpayer’s gross income for the taxable year
on account of a judgment or settlement resulting from such claim. Sec. 62(a)(20)
(last sentence).
At trial respondent conceded that petitioners were entitled to deduct under
section 62(a)(20) a portion of the settlement amount allocated to attorney’s fees
and court costs.14 On brief, respondent argues that petitioners can deduct only
14
It appears to be factually inconsistent for petitioners to maintain, on the
one hand, that the $250,000 was includible in their gross income “on account of a
(continued...)
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$113,985.60 because Mr. Anton represented to respondent that this was what he
received. Petitioners maintain the entire $152,000 is deductible because Mr.
Anton used $38,014.40 of the $152,000 to reimburse petitioners for the court costs
that they paid over the years of the litigation.
Deductions are a matter of legislative grace, and a taxpayer bears the burden
of producing sufficient evidence to substantiate any allowable deduction under the
Code. Sec. 6001; Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84
(1992); sec. 1.6001-1(a), Income Tax Regs. Under the familiar Cohan rule, where
a taxpayer is able to demonstrate that she has paid or incurred a deductible
expense but cannot substantiate the precise amount, the Court may estimate the
amount of the expense if the taxpayer produces credible evidence providing a
reasonable basis for the Court to do so. Cohan v. Commissioner, 39 F.2d 540, 544
(2d Cir. 1930); Vanicek v. Commissioner, 85 T.C. 731, 743 (1985).
14
(...continued)
judgment or settlement * * * resulting from * * * [an unlawful discrimination
claim]” and on the other hand, that Ms. Simpson and Sears intended to allocate the
entire settlement value to Ms. Simpson’s workers’ compensation claims and
nothing to the employment discrimination suit. If none of the $250,000 was
allocable to the unlawful discrimination suit and if Sears would not have entered
into the settlement agreement but for Ms. Simpson’s workers’ compensation
claims, it would appear that none of the attorney’s fees and court costs are
deductible under sec. 62(a)(20) by virtue of the last sentence of that section. But
because respondent has conceded this issue, we need not address it.
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Mr. Anton testified credibly at trial that $38,014.40 was paid to reimburse
petitioners for the court costs relating to Ms. Simpson’s unlawful discrimination
suit. In other words, Mr. Anton’s testimony shows that petitioners paid
$38,014.40 in court costs and $113,985.60 in attorney’s fees. The settlement
agreement that Ms. Simpson and Sears negotiated at arm’s length corroborates Mr.
Anton’s testimony. In sum, the credible evidence on this issue provides a
reasonable basis for us to conclude that petitioners paid $152,000 in attorney’s
fees and court costs. Accordingly, they are entitled to deduct this amount under
section 62(a)(20).
Any arguments not discussed in this Opinion are irrelevant, moot, or lacking
in merit.
To reflect the foregoing,
Decision will be entered under
Rule 155.