January 19, 2010 12:00 am

Settlement to Terminated Employee with MS Was Excludable Damages

Damages received from lawsuits and settlements are excludable from gross income only if they are based on a tort or tort-type right and are received on account of physical personal injury or illness. When there is a workplace action, it is not easy to discern whether the payments are compensation, which would make the payments taxable, or for personal physical illness, which would mean they are excludable. Take the following case:

A person with multiple sclerosis (MS) worked as a fundraiser for a nonprofit organization. She managed her MS symptoms, but circumstances at work made her condition flair up. She discovered her boss was embezzling funds, which she reported to the directors, but was still expected to do fundraising while the embezzlement continued. Her doctor prescribed 2 weeks’ rest, during which time she was terminated from her job. A lawsuit was settled, paying compensation owed to her and legal fees. The balance was reported to her on Form 1099-MISC as nonemployee compensation. She did not include this balance in income on the grounds that it was excludable damages. The Tax Court agreed.

In this case, the action was clearly tortlike, so the only issue was proving that the damages were received on account of personal physical injury. There must be a direct causal link between the damages and the personal injuries sustained. This link was clearly established here because it was exposure to a hostile and stressful work environment that exacerbated her MS symptoms to the point where she could not work. While the settlement agreement did not specify that the damages were paid for this purpose, the inference is clear.

Source: Julie Leigh Domeny; T.C. Memo. 2010-9

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Tax Glossary

Ordinary and necessary

A statutory requirement for the deductibility of a business expense.

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