James D. Ktsanes v. Commissioner , 2014 T.C. Summary Opinion 85 ( 2014 )

PURSUANT TO INTERNAL REVENUE CODE
SECTION 7463(b),THIS OPINION MAY NOT
BE TREATED AS PRECEDENT FOR ANY
OTHER CASE.
T.C. Summary Opinion 2014-85
UNITED STATES TAX COURT
JAMES D. KTSANES, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 21592-11S. Filed September 2, 2014.
James D. Ktsanes, pro se.
Rachel L. Paul, for respondent.
SUMMARY OPINION
ARMEN, Special Trial Judge: This case was heard pursuant to the
provisions of section 7463 of the Internal Revenue Code in effect when the
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petition was filed.1 Pursuant to section 7463(b), the decision to be entered is not
reviewable by any other court, and this opinion shall not be treated as precedent
for any other case.
Respondent determined a deficiency in petitioner’s Federal income tax for
2009 of $3,634. The issue for decision is whether any portion of the $65,000 that
petitioner received in 2009 in settlement of a dispute with Union Security
Insurance Co. (Union Security) is excludable from his gross income under section
104(a)(2) on account of personal physical injuries or physical sickness. If not,
then alternatively whether any portion of such amount is excludable under either
section 104(a)(1) as an amount received under a workmen’s compensation act or
section 104(a)(3) as an amount received through accident or health insurance. We
hold that no portion of the $65,000 is excludable under any of these paragraphs of
section 104(a).
1
Unless otherwise indicated, all subsequent section references are to the
Internal Revenue Code in effect for 2009, the taxable year in issue. All Rule
references are to the Tax Court Rules of Practice and Procedure.
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Background
Some of the facts have been stipulated, and they are so found. We
incorporate by reference the stipulated facts and the related exhibits.2
Petitioner’s legal residence at the time that the petition was filed was in the
State of Maine.
Petitioner served in the U.S. Marine Corps, achieving the rank of sergeant.
At the end of his military service he was employed by Coast Community College
District (CCCD) in Orange County, California, from about 1988 through 1998,
and then again from February 2004 through June 2006. During his first period of
employment at CCCD petitioner worked as a campus public safety officer. During
his second period of employment petitioner worked as the Assistant Director of
Workforce and Economic Development, a federally funded program to help
displaced workers.
While an employee of CCCD, petitioner was covered under a group long-
term disability insurance policy issued by Union Security to CCCD for the benefit
of its employees. The insurance premiums for the long-term disability policy were
2
Respondent reserved objections in the stipulation of facts, generally based
on relevancy and hearsay, to many of petitioner’s exhibits. See Rule 91(d). The
Court overrules respondent’s objections given the more relaxed evidentiary
standard applicable to small tax cases. See Rule 174(b).
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paid by CCCD. Petitioner did not pay any portion of the premiums on the policy,
and the monetary value of the payments for coverage under the policy was not
includible in his gross income.
On or around February 22, 2006, petitioner was diagnosed with Bell’s palsy,
which led to his inability to work. On March 2, 2006, petitioner filed a claim for
short-term disability benefits. Petitioner received short-term disability payments
from Union Security from May through June 2006. Petitioner’s employment with
CCCD ended in June 2006.
In or around November 2006, presumably after the applicable “elimination
period” provided by the policy had ended, petitioner filed a claim with Union
Security for long-term disability benefits. In or around March 2007 Union
Security denied petitioner long-term disability benefits on the ground that he was
not totally disabled.
Petitioner then entered into extended correspondence, principally with
CCCD, attempting to establish his entitlement to long-term disability benefits.
When his attempts proved unsuccessful, petitioner filed a complaint on October
17, 2008, against Union Security and multiple unknown parties (identified as
“Does 1 through 20” in the complaint) with the Superior Court of the State of
California County of Orange. The complaint alleged in relevant part:
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7. At all relevant times, there was in full force and effect a policy of
insurance providing long term [sic] disability benefits, underwritten
and issued by defendant, UNION SECURITY, to the Coast
Community College District, which covered plaintiff as an employee
(Assistant Director, Workforce & Economic Development [a
federally funded program to help displaced workers]), and which
promised to pay certain long term [sic] disability benefits should he
become totally disabled (as defined by California law) and unable to
perform the substantial and material duties of his occupation in the
usual and customary way. Long Term Disability Benefits were to be
paid for the duration of disability, with a monthly benefit (subject to
certain offsets) of 60% of plaintiff’s monthly income of
approximately $6100.00 per month, for a monthly benefit of
approximately $3660.00, following an initial elimination period of
approximately 100 days. A true and correct copy of the Certificate of
Insurance, Policy No. 403456 (hereinafter “the Policy”), originally
issued by and through the Fortis Benefits Insurance Company, and
subsequently underwritten by UNION SECURITY and administered
by ASSURANT Employee Benefits, is attached as Exhibit “A” and
incorporated herein by this reference.
8. All premiums due under the Policy have been paid to UNION
SECURITY by plaintiff and/or on his behalf, at all relevant times, and
plaintiff has performed all obligations under the Policy on his part to
be performed.
9. On or about February 22, 2006, plaintiff became totally disabled
from his occupation due to a condition of Bell’s Palsy, a neuro-
muscular disorder causing, among other symptoms, facial paralysis.
Plaintiff became unable to work at that time and remained totally
disabled through approximately August of 2007. After receiving
short-term disability benefits from approximately May through June
of 2006, plaintiff filed his claim for long-term disability benefits in
approximately November of 2006. On March 14, 2007, by way of a
letter from ASSURANT of that date from Claims Specialist Nell
Horstman, defendant denied all long-term disability benefits to
plaintiff, asserting that plaintiff was not totally disabled. In fact, from
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February 2006 through August of 2007, plaintiff’s injuries and
medical condition prevented him from performing the substantial and
material duties of his regular occupation in the usual and customary
way, and thus was totally disabled under construing California law.
10. Following the submission of his claim for benefits, UNION
SECURITY has paid no long-term disability benefits to plaintiff. For
several months following his claim, and despite knowledge of his
existing and on-going disability, documented by appropriate medical
testing (for example, a positive MRI), defendant undertook little or no
investigation of the claim, conducted no IME (independent medical
examination), made no claims determinations until March of 2007,
and paid no benefits to plaintiff, instead summarily denying benefits.
The complaint alleged two causes of action: breach of contract and breach
of covenant of good faith and fair dealing. With respect to the breach of contract
cause of action, the complaint alleged:
12. UNION SECURITY breached the subject insurance contract by
refusing without just cause to pay long-term disability benefits to
plaintiff as required under the Policy.
13. As a direct and proximate result of defendant’s breach of the
insurance contract, plaintiff has suffered contractual damages under
the terms and conditions of the Policy, and other incidental damages
and out-of-pocket expenses, all in a sum to be determined at the time
of trial.
With respect to the breach of the covenant of good faith and fair dealing
cause of action, the complaint alleged:
15. UNION SECURITY has breached its duty of good faith and fair
dealing owed to plaintiff in the following respects:
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(a) unreasonable and bad faith failure to pay long-term
disability benefits to plaintiff at a time when defendant knew that
plaintiff was entitled to such benefits under the terms of the Policy;
(b) unreasonable and bad faith withholding of disability
benefits from plaintiff knowing his claim to be valid;
(c) unreasonable and bad faith failure to pay long-term
disability benefits to plaintiff at a time when the medical information
available to defendant, including a positive MRI, showed his
entitlement to benefits and at time when defendant had insufficient
information within its possession to justify the denial of benefits;
(d) unreasonably denying benefits to plaintiff without
adequately investigating the claim;
(e) unreasonably denying benefits at a time when defendant
had conducted no independent medical examination;
(f) failing to reasonably investigate and process plaintiff’s
claim for long-term disability benefits;
(g) unreasonably failing to attempt to effectuate a prompt, fair,
and [sic] settlement of plaintiff’s claim for disability benefits at a time
when liability had become reasonably clear; and
(h) unreasonably failing to adhere to California law applicable
to plaintiff’s claim for benefits by its failure to consider the real world
marketplace for employment for plaintiff, and instead asserting that
plaintiff was not disabled from “a group of jobs” which plaintiff was
allegedly able to perform, as opposed to his own occupation.
* * * * * * *
17. As a proximate result of the aforementioned wrongful conduct of
defendant, plaintiff has suffered, and will continue to suffer in the
future, damages under the Policy, plus interest, for a total amount to
be shown at the time of trial.
18. As a further proximate result of the aforementioned wrongful
conduct of UNION SECURITY, plaintiff has suffered, and will
continue to suffer, anxiety, worry, mental and emotional distress, and
other incidental damages and out-of-pocket expenses, all to his
general damages in a sum to be determined at the time of trial.
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19. As a further proximate result of the aforementioned wrongful
business practices and conduct of defendant, plaintiff has been
required to retain legal counsel to obtain the benefits and coverage
due him under the Policy. Therefore, defendant is liable to plaintiff
for those attorneys fees incurred by him in order to obtain the benefits
under the Policy in a sum to be determined at the time of trial.
The complaint ended with a prayer for relief, wherein petitioner sought the
following:
1. damages for failure to provide long-term disability insurance
benefits contractually owed to plaintiff under the Policy, plus interest,
including pre-judgment interest, in a sum to be determined at the time
of trial;
2. general damages for mental and emotional distress and other
incidental damages in a sum to be determined at the time of trial
(Second Cause of Action);
3. punitive and exemplary damages in an amount appropriate to
punish or set an example of defendant (Second Cause of Action);
4. consequential damages and out-of-pocket expenses related to the
denial of benefits in an amount which will compensate for all the
detriment proximately caused by defendant;
5. Brandt attorney fees[3] incurred by plaintiff to obtain the benefits
under the Policy in a sum to be determined at the time of trial (Second
Cause of Action);
6. pre-judgment interest at the appropriate legal rate;
3
Brandt v. Superior Court, 693 P.2d 796 (Cal. 1985) (holding that when an
insurer withholds benefits under an insurance policy, attorney’s fees reasonably
incurred to compel the payment of such benefits are recoverable).
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7. costs of suit incurred herein; and
8. such other and further relief as the Court deems just and proper.
In December 2009 petitioner and Union Security executed a Settlement
Agreement and Release (settlement agreement). It stated in relevant part as
follows:
1. Prefatory Statement.
* * * * * * *
a. A dispute arose between the Parties that involved, among
other things, claims regarding certain disability income benefits
allegedly due under the terms and conditions of a group long-term
disability insurance police issued by USIC [Union Security] to Coast
Community College District (“CCCD”), * * * which provided
coverage to Ktsanes as an employee of CCCD.
* * * * * * *
c. The Parties now deem it in their best interests and for their
mutual advantages to resolve, compromise and release by this
Agreement all disputes between them relating to any alleged
disabling condition(s), benefits allegedly due to Ktsanes under the
terms and conditions of the Policy and USIC’s handling and/or
investigation of Plaintiff’s claims for benefits, including, but not
limited to, the claims described above and in Section 5 below as well
as any and all future claims for benefits under the Policy.
2. Payment.
USIC shall pay the Law Offices of Robert K. Scott the sum of Sixty-
Five Thousand Dollars and Zero Cents ($65,000.00) without
deduction or offset (hereinafter referred to as the “Payment”), made
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payable to the Robert K. Scott, APC, Client Trust Account (“Trust
Account”). USIC will make the Payment within ten (10) days
following the tender of the executed Agreement by Ktsanes and
USIC’s counsel.
3. Surrender of Coverage.
Ktsanes represents, warrants, and agrees that he surrenders all of his
coverage under any policy of insurance issued by USIC, including the
Policy and any and all life insurance policies. Ktsanes further agrees
that in the future he shall be deemed ineligible to become insured
under any current or future policy issued, administered or
underwritten by USIC. If Ktsanes becomes employed in the future
with a group that is insured or underwritten by USIC, this paragraph
will not have application.
* * * * * * *
5. Releases, Representations and Warranties.
a. Ktsanes, on his own behalf, and on behalf of his respective
predecessors, successors, heirs, assigns, agents, and legal
representatives, does hereby relieve, release and forever discharge
USIC and its owners, administrators, sponsors, transferees, grantees,
legatees, shareholders, partners, officers, directors, brokers,
employees, agents, representatives, attorneys, reinsurers, past or
present subsidiaries, predecessors, successors, assigns, parent
corporations, affiliated corporations or entities, employee benefit
plans thereof, sponsors, plan administrators and heirs, including those
who may assume any and all of the above-described capacities
subsequent to the execution and effective date of this Agreement (all
sometimes collectively referred to herein as “Releasees”), of and from
any and all claims of any nature whatsoever, known or unknown,
fixed or contingent, whether at law or at equity, from the beginning of
time to the date hereof, arising out of any alleged disabling
condition(s) and claims for benefits allegedly due to Ktsanes, under
the Policy and/or the related benefit Plan (collectively referred to as
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the “Claims”) which were or could have been asserted in a Civil
Action, including but without in any way limiting the generality of
the foregoing, any and all claims arising out of Ktsanes’ participation
in the Policy and/or Plan, USIC’s conduct in handling, investigating,
administering or denying Plaintiff’s claims for benefits under the
Policy and/or Plan and any and all claims for benefits or claims
resulting from any alleged known or unknown breach of any contract
or statute referred to in the Civil Action, or any other alleged common
count, tort, or extra contractual claims arising out of or in any way
connected with the dispute surrounding the claims for benefits
allegedly due to Ktsanes * * *
* * * * * * *
c. Ktsanes has received independent legal advice from
attorneys of his own choice with respect to the advisability of
executing this Agreement, requesting the dismissal of the Civil
Action and the meaning of California Civil Code Section 1542
[relating to general release of claims].
d. Ktsanes’ attorneys are knowledgeable of the facts and issues
raised in the Civil Action and are experienced and competent to
advise Ktsanes with regard to the terms, conditions and advisability
of executing this Agreement.
* * * * * * *
h. Ktsanes acknowledges that USIC has not provided any
advice to Ktsanes about the tax consequences, if any, of this
Agreement and any such tax consequences are Ktsanes’ sole
responsibility.
6. Termination of Contractual Relationships and Rights.
Ktsanes expressly agrees and recognizes that any relationship,
contractual or otherwise, previously or now existing between Ktsanes
and Releasees is permanently and irrevocably terminated and any and
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all insurance coverage of any kind afforded to Ktsanes by Releasees
is canceled, void and terminated, effective immediately.
* * * * * * *
10. Tax Liability.
Ktsanes understands and acknowledges that USIC will report the
Payment to the Internal Revenue Service in the same manner as any
periodic long-term [sic] disability benefits under the policy.
11. Indemnification.
Ktsanes hereby agrees to indemnify and hold any and all Releasees
harmless from and against any claim, demand, damage, debt, liability,
account, reckoning, obligation, cost, expense, lien, action or cause of
action (including payment of attorneys’ fees and costs actually
incurred whether or not litigation is commenced) of any nature
incurred by Releasees, or any Releasee, as a result of any person or
entity asserting any rights or claims under the Policy or in connection
with any of the issues raised in the Civil Action. This indemnity does
not require payment as a condition precedent to recovery by
Releasees, or any Releasee, against Ktsanes.
* * * * * * *
18. Joint Preparation.
Ktsanes has cooperated and participated in the drafting and
preparation of this Agreement. Therefore, any construction to be
made of this Agreement shall not be construed against USIC or any
Releasees.
In sum, both the relief sought by petitioner and the $65,000 payment
ultimately agreed to by Union Security in the parties’ settlement agreement
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contemplated a resolution of his claim for long-term disability benefits. The
settlement agreement did not allocate any part of such payment to physical injuries
or physical sickness; rather, the settlement agreement provided that Union
Security’s payment to petitioner would be reported to the IRS as long-term
disability benefits under the policy.
The settlement agreement was never submitted to the California Workers’
Compensation Appeals Board (WCAB) for approval, nor did petitioner obtain
approval of the settlement from the WCAB.
Union Security subsequently paid petitioner $65,000 in 2009 consistent
with the settlement agreement. Union Security issued a Form W-2, Wage and Tax
Statement, which reported that petitioner received $65,000 of third-party sick pay
in 2009.
Petitioner timely filed a Form 1040, U.S. Individual Income Tax Return, for
2009. On it petitioner acknowledged receipt of $65,000 from Union Security but
excluded such amount from taxable income.
Respondent issued a notice of deficiency in June 2011. In it respondent
adjusted petitioner’s taxable income to include the $65,000 that petitioner had
previously excluded.
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Petitioner timely filed a petition for redetermination of the deficiency.
Ultimately the case was recently tried before the Court.
Discussion
We decide the issues in this case without regard to the burden of proof.
Accordingly, we need not decide whether the general rule of section 7491(a)(1) is
applicable in this case. See Higbee v. Commissioner, 116 T.C. 438 (2001).
Gross income generally includes all income from whatever source derived,
unless specifically excluded. Sec. 61(a); Commissioner v. Glenshaw Glass Co.,
348 U.S. 426, 429 (1955). It is also well established that statutory exclusions from
gross income, such as those provided in section 104, are to be narrowly construed,
see Commissioner v. Schleier, 515 U.S. 323, 328 (1995), and that the taxpayer
must fall squarely within the requirements of an exclusion for it to apply, Dobra v.
Commissioner, 111 T.C. 339, 349 n.16 (1998); Forste v. Commissioner, T.C.
Memo. 2003-103, 2003 WL 1889626, at *7.
Section 104(a)(2) excludes from gross income the amount of any damages
(other than punitive damages) received (by suit or agreement) on account of
personal physical injuries or physical sickness. In addition, under section
104(a)(1) amounts received under workmen’s compensation acts that compensate
for occupational personal injuries or sickness are excludable from income.
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Finally, under section 104(a)(3), amounts received through accident or health
insurance for personal injuries or sickness are excludable from gross income
unless such amounts are either (1) attributable to contributions by the employer
that were not includible in the gross income of the employee or (2) paid by the
employer.
Petitioner argues that the entire settlement amount in issue, $65,000, is
excludable from gross income under section 104(a)(2) as an amount received on
account of physical injuries or physical sickness, or, alternatively, that it is
excludable under section 104(a)(1) as an amount received under California’s
workers’ compensation laws. Although petitioner does not expressly invoke
section 104(a)(3), the Court nonetheless considers whether that section might
apply.
A. Section 104(a)(2)
1. Requirements for Exclusion
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
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personal injuries or sickness.’”4 Commissioner v. Schleier, 515 U.S. at 337. The
requirement that the recovery be based upon tort-like action was rooted in the
former regulations under section 104 (former regulations). See Simpson v.
Commissioner, 141 T.C. 331, 345 (2013) (citing United States v. Burke, 504 U.S.
229, 234 (1992), and T.D. 6500, 25 Fed. Reg. 11402, 11490 (Nov. 26, 1960)); see
also sec. 1.104-1(c), Income Tax Regs. (before amendment by T.D. 9573, 2012-12
I.R.B. 498).
In 2012 the Secretary amended the regulations and abandoned the “based
upon tort or tort-type rights” requirement so long as recovery is on account of
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. 1.104-1(c), Income Tax
Regs.
The parties do not dispute the applicability of the new regulations, and in
the instant case the Court applies them as written.5 See Simpson v. Commissioner,
4
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.
5
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 petitioner; therefore, the Court applies the regulations retroactively
(continued...)
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141 T.C. 346. In short, under the applicable regulations, some or all of the
payments may be excluded from gross income under section 104(a)(2) if the
taxpayer can show the amount of damages received on account of the taxpayer’s
physical injuries or physical sickness.
2. Payment Received “On Account Of” Union Security’s Denial
of Petitioner’s Claim for Long-Term Disability Benefits
In O’Gilvie v. United States, 519 U.S. 79, 83 (1996), the Supreme Court
read the phrase “on account of” to require a “strong[] causal connection”, thereby
making section 104(a)(2) “applicable only to those personal injur[ies] lawsuit
damages that were awarded by reason of, or because of, the personal injuries.”
See also Murphy v. IRS, 493 F.3d 170, 175 (D.C. Cir. 2007). The Supreme Court
specifically rejected a “but for” formulation in favor of a “stronger causal
connection”. O’Gilvie v. United States, 519 U.S. at 82-83.
The relief that petitioner sought in his complaint was causally connected
(and strongly so) to the denial by Union Security of his claim for long-term
disability benefits. Although petitioner’s complaint alleged that he became
disabled as a result of physical injuries or sickness, this “but for” connection is
insufficient to satisfy the “on account of” relationship discussed in O’Gilvie for
5
(...continued)
for his benefit.
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purposes of the exclusion under section 104(a)(2). Petitioner would not have filed
his complaint if Union Security had not denied his claim but instead paid him the
long-term disability payments that he sought. In other words, petitioner sought
compensation “on account of” the denial of his long-term disability benefits, not
for any physical injuries or physical sickness. See O’Gilvie v. United States, 519
U.S. 79. Accordingly, the Court concludes that the $65,000 payment was not
made “on account of” physical injuries or physical sickness within the meaning of
section 104(a)(2).
3. Complaint, Settlement Agreement, and the Payor’s Intent
In addition to the foregoing, when 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 the Court’s decision whether such payment is
excludable from income under section 104(a)(2). See United States v. Burke, 504
U.S. at 237; Simpson v. Commissioner, 141 T.C. 339-340; Molina v.
Commissioner, T.C. Memo. 2013-226, at *10. Thus, whether the settlement
payment is excludable from gross income depends on the nature and character of
the claims asserted and not upon the validity of those claims. Bent v.
Commissioner, 87 T.C. 236, 244 (1986), aff’d, 835 F.2d 67 (3d Cir. 1987); Church
v. Commissioner, 80 T.C. 1104, 1106-1107 (1983). In short, the Court looks to
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the specific claims for which the settlement was paid. Bagley v. Commissioner,
105 T.C. 396, 406 (1995), aff’d, 121 F.3d 393 (8th Cir. 1997); Kees v.
Commissioner, T.C. Memo. 1999-41, 1999 WL 54695, at *3 (citing Allen v.
Commissioner, T.C. Memo. 1998-406).
Thus, 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?” Raytheon Prod. Corp. v. Commissioner, 144 F.2d 110, 113
(1st Cir. 1944), aff’g 1 T.C. 952 (1943); Fono v. Commissioner, 79 T.C. 680, 692
(1982), aff’d without published opinion, 749 F.2d 37 (9th Cir. 1984). To justify
the exclusion from income under section 104(a)(2), petitioner must show that his
settlement proceeds were in lieu of damages for physical injuries or physical
sickness. See Green v. Commissioner, 507 F.3d 857, 867 (5th Cir. 2007), aff’g
T.C. Memo. 2005-250; Ahmed v. Commissioner, T.C. Memo. 2011-295, 2011 WL
6440130, at *3, aff’d, 498 Fed. Appx. 919 (11th Cir. 2012).6 The determination of
the nature of the underlying claim is factual. Bagley v. Commissioner, 105 T.C.
6
See Espinoza v. Commissioner, T.C. Memo. 2010-53, aff’d, 636 F.3d 747
(5th Cir. 2011); Save v. Commissioner, T.C. Memo. 2009-209, 2009 WL 2950838
at *2 n.5 (stating that although cases were decided under sec. 104(a)(2) before it
was amended in 1996, their holding regarding the characterization of settlement
proceeds in lieu of damages remains good law).
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406; Robinson v. Commissioner, 102 T.C. 116, 126 (1994), aff’d in part, rev’d in
part, and remanded on another issue, 70 F.3d 34 (5th Cir. 1995).
Ultimately, the character of the payment hinges on the payor’s dominant
reason for making the payment. Green v. Commissioner, 507 F.3d at 868. The
Court looks first to the language of the agreement itself for indicia of purpose. Id.
at 867; Knuckles v. Commissioner, 349 F.2d 610, 613 (10th Cir. 1965), aff’g T.C.
Memo. 1964-33; Robinson v. Commissioner, 102 T.C. 126. If the settlement
lacks express language stating what the amount paid pursuant to the agreement
was to settle or is otherwise not clear, the Court looks to the intent of the payor,
considering all of the facts and circumstances. Knuckles v. Commissioner, 349
F.2d at 613; Robinson v. Commissioner, 102 T.C. 127; Ahmed v.
Commissioner, 2011 WL 6440130, at *3; Kees v. Commissioner, 1999 WL 54695,
at *3. Where the agreement does not mention purpose, the Court may look at
other facts that reveal the payor’s intent, such as the amount paid, the evidence
adduced at trial, and the factual circumstances that led to the agreement. Green v.
Commissioner, 507 F.3d at 868. Although the belief of the payee is relevant to
that inquiry, the character of the settlement payment hinges ultimately on the
dominant reason of the payor in making the payment. Agar v. Commissioner, 290
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F.2d 283, 284 (2d Cir. 1961), aff’g per curiam T.C. Memo. 1960-21; Fono v.
Commissioner, 79 T.C. 696.
Petitioner contends that the payment he received from the settlement
agreement was to compensate him for physical injuries or physical sickness, i.e.,
his Bell’s palsy, which ultimately led to him being unable to work and to filing a
claim for long-term disability. Although the complaint mentioned petitioner’s
Bell’s palsy, the complaint did not specifically seek relief for any physical injuries
or physical sickness. Instead, it sought damages for failure to provide long-term
disability insurance benefits, general damages for mental and emotional distress,
punitive and exemplary damages, consequential and out-of-pocket damages,
attorney’s fees, prejudgment interest, and the cost of the suit.
Neither the complaint nor the settlement agreement tends to show that the
$65,000 settlement amount was paid on account of physical injuries or physical
sickness, nor does the record show that the payor’s intent was to make the
payment for anything other than to satisfy petitioner’s claim for long-term
disability benefits.
Additionally, the settlement agreement did not allocate any portion of the
$65,000 to physical injuries or physical sickness. Rather, the settlement amount
was paid to satisfy petitioner’s claim for long-term disability benefits. Not only
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does the settlement agreement not mention any physical injuries or physical
sickness, it specifically states that Union Security would “report the Payment to
the Internal Revenue Service in the same manner as any periodic long-term
disability benefits received under the Policy”. And Union Security did so by
issuing a Form W-2 to petitioner reporting a payment of $65,000.
Granted, the settlement agreement’s boilerplate list of claims from which
petitioner agreed to release Union Security included “any and all claims * * *
arising out of any alleged disabling conditions(s)”. But, as just mentioned, the
settlement agreement did not allocate any portion of the payment to any claim for
physical injuries or physical sickness. See Molina v. Commissioner, T.C. Memo.
2013-226; Ahmed v. Commissioner, 2011 WL 6440130, at *3; Espinoza v.
Commissioner, T.C. Memo. 2010-53, aff’d, 636 F.3d 747 (5th Cir. 2011); Evans v.
Commissioner, T.C. Memo. 1980-142 (holding that failure to allocate a settlement
requires inclusion of the entire settlement payment in income). The Court has held
that the nature of underlying claims cannot be determined from a general release
that is broad and inclusive, see Connolly v. Commissioner, T.C. Memo. 2007-98,
and that all settlement proceeds are included in gross income where there is a
general release lacking any allocation of settlement proceeds among various
claims, see Evans v. Commissioner, T.C. Memo. 1980-142.
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In view of the foregoing, on the evidence the Court holds that section
104(a)(2) does not serve to exclude the $65,000 settlement from petitioner’s
income.
B. Section 104(a)(1)
Section 104(a)(1) excludes from gross income amounts received by an
employee under a workmen’s compensation act or under a statute in the nature of a
workmen’s 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 benefits were received under a
statute or a regulation. See Rutter v. Commissioner, 760 F.2d 466, 468 (2d Cir.
1985), aff’g T.C. Memo. 1984-525 (1984); see also Wallace v. United States, 139
F.3d 1165, 1167 (7th Cir. 1998). Therefore, for petitioner’s settlement payment to
constitute an amount “received under workmen’s compensation acts”, the
settlement agreement must comply with the statutory requirements to be valid
under California workers’ compensation laws.
California workers’ compensation laws provide that generally the WCAB
must approve any release or agreement to compromise an employer’s liability for
workers’ compensation benefits before the release or agreement becomes valid.
Cal. Lab. Code. sec. 5001 (West 2011). Furthermore, the parties must file the
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signed release or compromise with the WCAB for the Board to enter the award on
the basis of the release or agreement. Id. sec. 5002.
In the instant case, petitioner admits that he never submitted the settlement
agreement to the WCAB for approval, nor did he obtain approval of the settlement
from the WCAB. The settlement agreement thus fails to meet the express
requirement of California’s workers’ compensation laws that settlement approval
be obtained from the WCAB. Consequently, the $65,000 payment that petitioner
received pursuant to the settlement agreement was not received under the State’s
workers’ compensation act. See Simpson v. Commissioner, 141 T.C. 341-342
(discussing Steller v. Sears, Roebuck & Co., 116 Cal. Rptr. 3d (Ct. App. 2010)).
Accordingly, section 104(a)(1) does not serve to exclude the $65,000 settlement
payment from petitioner’s income.
C. Section 104(a)(3)
Generally, amounts received through accident or health insurance for
personal injuries or sickness are excluded from gross income under section
104(a)(3). This exclusion does not apply, however, if the amounts are either (1)
attributable to contributions by the employer that were not includible in the gross
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income of the employee or (2) paid by the employer.7 Sec. 104(a)(3); Hayden v.
Commissioner, T.C. Memo. 2003-184, aff’d, 127 Fed. Appx. 975 (9th Cir. 2005).
In the instant case, petitioner received $65,000 in 2009 from Union Security
in settlement of his claim that long-term disability benefits were due to him on the
basis of an accident or health insurance plan sponsored by an employer, CCCD.
See Watts v. Commissioner, T.C. Memo. 2009-103, 2009 WL 1391414, at *6.
However, the benefits of the long-term disability insurance policy and coverage
were attributable to contributions made by CCCD, petitioner’s employer, and the
contributions were not included in petitioner’s gross income. Therefore, section
104(a)(3) does not serve to exclude the settlement payment from gross income.
Conclusion
If in 2006 Union Security had approved petitioner’s claim for long-term
disability benefits under the group insurance policy issued to CCCD, receipt of
those benefits would have been taxable to petitioner. However, Union Security
denied the claim and petitioner found it necessary to sue, alleging breach of
contract and breach of the covenant of good faith and fair dealing. The $65,000
7
The exclusion does not extend to amounts attributable to deductions
allowed under sec. 213 (relating to medical expenses) for any prior taxable year.
See Watts v. Commissioner, T.C. Memo. 2009-103, 2009 WL 1391414, at *5
n.10.
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that petitioner received in settlement of his suit essentially represented a substitute
for what he would have received had his claim been approved. Under these
circumstances, no part of that payment is excludable under any subdivision of
section 104(a). Respondent’s determination is therefore sustained.
To give effect to our disposition of the disputed issue,
Decision will be entered for
respondent.