Settlement proceeds partially taxable due to failure to comply with state workers compensation laws, Tax Court holds

A recent Tax Court case regarding the taxability of the proceeds of a settlement of a lawsuit illustrates the complex relationship between federal income tax law and the underlying state laws that govern the employer/employee relationship, Simpson v. Commissioner, 141 TC #10 (Oct 28, 2013).  After Kathleen Simpson lost her job working for Sears, she initiated a lawsuit that claimed damages on the grounds that she had been injured on her job, and that she had been the victim of unlawful discrimination.   The court granted Sears’ motion for summary judgment on the causes of action related to employment discrimination, but allowed the case to move forward on the grounds of physical injury, based on her allegation that the employer had not complied with the requirements of state workers compensation law.

After the dismissal of the discrimination-related causes of action, she settled the case for a total amount of $262,500.  The settlement amount was broken down into $12,500 for lost wages, $98,000 for emotional distress, physical and mental injury, and $152,000 to the attorney for attorney’s fees and court costs. The settlement agreement provided that it was governed by California law, and that any further actions related to the case were barred.  No workers compensation claim was ever filed, nor was the settlement agreement submitted to the California Workers Compensation Appeals Board for approval.  On her tax return, the plaintiff reported $12,500 as taxable income, and excluded the remainder of the settlement from income.

Under the Internal Revenue Code, amounts received under workmen’s compensation acts as compensation for personal injuries or sickness  are excluded from income, IRC § 104(a)(1).  When a person receives a payment in settlement of a legal claim, the taxability of the payment is determined based upon the nature of the claim settled.  Accordingly, there seems to be a valid argument for her treatment of the settlement proceeds as non-taxable:  the settlement seems to have been in lieu of a workmen’s compensation payment, and so should be eligible for the same tax treatment.

The Tax Court found there to be credible evidence that the primary claim settled was for the physical injury claim, governed by the workers compensation statute. Unfortunately for the plaintiff, however, settlement of workers compensation claims is the subject of strict regulation under California law.  Any such settlement must be submitted to the California Workers Compensation Appeals Board for approval.  Citing California case law, the Tax Court held that the failure of Simpson’s attorney to comply with this requirement invalidated the settlement.  Thus, although the validity of the settlement was not contested by the defendant, the failure to comply with state law made it legally unenforceable.  As a consequence of this failure, it could not be considered a payment made under a workmen’s compensation act within the meaning of the Internal Revenue Code.

The Court allowed the portion of the settlement that was explicitly paid for physical injury to be excluded from income tax.  The remainder of the settlement, however, which was neither paid for physical injury nor paid under an applicable workers compensation act, could not be excluded from income.