Kathleen S. Simpson & George T. Simpson v. Commissioner

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 specifi-
cally 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’ com-
pensation laws. Ten percent of the settlement award 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
331
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332 141 UNITED STATES TAX COURT REPORTS (331)
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 phys-
ical 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 pen-
alty under section 6662(a) of $14,681. 1 Petitioners, while
residing in California, timely petitioned this Court to redeter-
mine respondent’s determination. Following respondent’s
concession that petitioners are not liable for the accuracy-
related penalty, we decide: (1) whether any portion of
$250,000 2 petitioners received in 2009 in settlement of a dis-
pute 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;
and (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 per-
formed various jobs such as data retrieval, project manage-
ment, compensation management, and human resources. In
1 Unless otherwise indicated, section references are to the Internal Rev-
enue Code (Code) in effect for the year in issue, and Rule references are
to the Tax 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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(331) SIMPSON v. COMMISSIONER 333
the latter part of the 1990s Ms. Simpson began taking on
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 mer-
chandise. 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 Fair-
field store was a problem store in that the prior store man-
ager and prior numerous management and staff were termi-
nated and almost the entire staff had less than one year of
management experience.
Because of the problems at the store and the need to pro-
vide 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 considered commit-
ting suicide. She sought counselors and physicians for treat-
ment 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
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334 141 UNITED STATES TAX COURT REPORTS (331)
had requested a transfer because of her work-related clinical
depression and physical illness.
After not hearing back from Ms. Mallory about her com-
plaints, 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 clin-
ical 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 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 Cali-
fornia 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.
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 dis-
ability. The other claim under Cal. Gov’t Code sec. 12940(n)
alleged that Sears failed to engage in an interactive process
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(331) SIMPSON v. COMMISSIONER 335
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, emo-
tional distress, mental pain and suffering, and physical
injury. Ms. Simpson sought economic damages (e.g., back and
future pay), noneconomic damages (e.g., compensatory dam-
ages 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 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 discus-
sions. 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 cer-
tain workers’ compensation benefits, including benefits for
temporary disabilities and permanent disabilities resulting
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.
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336 141 UNITED STATES TAX COURT REPORTS (331)
from work-related injuries, if she had filed such a claim. 4
Mr. Anton believed 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’ compensa-
tion eligibility and benefits, as the amount of temporary dis-
ability 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 attor-
ney’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., 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 Com-
pany 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 law-
suit]. SIMPSON also promises that she will not seek any further com-
4 Mr. Anton had initially argued for vocational retraining benefits in ad-
dition to temporary disability and permanent disability benefits but did
not include these benefits in the final settlement value.
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(331) SIMPSON v. COMMISSIONER 337
pensation 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, explaining the nature of the
$250,000 proceeds reported in petitioners’ Form 1099–MISC,
Miscellaneous Income, received from Sears and why peti-
tioners 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 dis-
ability 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 ill-
ness, and Ms. Simpson should have been accommodated by being pro-
vided 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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338 141 UNITED STATES TAX COURT REPORTS (331)
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 sec-
tion 104(a)(1), ‘‘amounts received under workmen’s com-
pensation acts’’ to compensate for personal injuries or sick-
ness 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 per-
sonal 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 Califor-
nia’s workers’ compensation laws. Petitioners argue alter-
natively that (1) up to 20% of the $98,000 settlement figure
allocated to ‘‘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 phys-
ical injuries and physical sickness and that (2) petitioners
are entitled to deduct under section 62(a)(20) $152,000 allo-
cated to attorney’s fees and court costs in connection with
Ms. Simpson’s FEHA action involving unlawful discrimina-
tion claims.
I. Burden of proof
The Commissioner’s determinations in a notice of defi-
ciency 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
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(331) SIMPSON v. COMMISSIONER 339
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 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 peti-
tioners’ allegations, either by cross-examination or by pro-
ducing 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 pay-
ments) on account of personal physical injuries or physical
sickness’’. Sec. 104(a)(1) and (2). 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 settle-
ment 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 ques-
tion to be asked is: ‘‘In lieu of what were the damages
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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340 141 UNITED STATES TAX COURT REPORTS (331)
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. Commis-
sioner, 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 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 ulti-
mate 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 consider-
ation in determining whether payment is gift). Under Cali-
fornia law, which governs the interpretation of Ms. Simpson’s
settlement agreement with Sears, we must consider all cred-
ible evidence to determine whether the language of the
agreement is fairly susceptible of more than one interpreta-
tion, 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
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 con-
text of sec. 104(a)(2). While sec. 104(a)(1) does not explicitly mention settle-
ment, we find it helpful here to look to cases like Burke and Fono to deter-
mine 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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(331) SIMPSON v. COMMISSIONER 341
FEHA lawsuit as well as ‘‘any other matters involving SIMP-
SON’s former employment relationship with * * * [Sears]’’,
but it falls short of expressly including Ms. Simpson’s
workers’ compensation claim. Indeed, the settlement agree-
ment includes multiple references to the FEHA lawsuit but
does not mention Ms. Simpson’s potential workers’ com-
pensation claims at all. But we also accept Mr. Anton’s cred-
ible 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 settle-
ment agreement ought to place Ms. Simpson’s workers’ com-
pensation claims under the settlement agreement although
the agreement itself does not state so expressly.
Ambiguity also arises where California’s workers’ com-
pensation 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 ambi-
guity in settlement agreement and concluding on extrinsic
evidence that settlement encompassed workers’ compensation
claim and disability discrimination claim).
We find Ms. Simpson and Mr. Anton to be generally cred-
ible. 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’ com-
pensation 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 settle-
ment from Sears only on the basis of Ms. Simpson’s entitle-
ment to workers’ compensation benefits. Mr. Anton also testi-
fied credibly that the $98,000 amount was determined by ref-
erence to the disability benefits provided under California’s
workers’ compensation laws for the ‘‘emotional distress, phys-
ical and mental disability’’ that Ms. Simpson suffered while
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342 141 UNITED STATES TAX COURT REPORTS (331)
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 emo-
tional 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.
B. Section 104(a)(1)
The intent of the parties to a settlement of a workers’ com-
pensation 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 per-
sonal 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. 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 juris-
diction’ ’’, 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. Commis-
sioner, 760 F.2d at 468). Thus, for Ms. Simpson’s settlement
payment to be an amount ‘‘received under workmen’s com-
pensation acts’’, the settlement agreement must comply with
the statutory requirements to be valid under 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
7 It is conceivable that under certain statutory regimes, parties may pri-
vately 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.
8 For example, compensation received for an occupational injury or sick-
ness in excess of the amount provided in the applicable workers’ compensa-
tion act is not excludable. Sec. 1.104–1(b), Income Tax Regs.
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(331) SIMPSON v. COMMISSIONER 343
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 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 conclu-
sion. 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 simulta-
neously 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 employ-
ment; the settlement agreement did not expressly mention
the pending workers’ compensation action. Id. at 179. The
trial court entered a judgment in the disability discrimina-
tion action according to the terms of the compromise agree-
ment. 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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344 141 UNITED STATES TAX COURT REPORTS (331)
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 com-
promise 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’ com-
pensation claims because the parties failed to obtain the req-
uisite approval from the WCAB. Because neither Sears nor
Ms. Simpson has taken the crucial step to submit the settle-
ment agreement for the WCAB’s approval, any payments
received under the settlement are not ‘‘amounts received
under workers’ compensation acts’’. See Forste v. Commis-
sioner, 85 T.C.M. (CCH) at 1152 n.15.
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 sick-
ness.’’
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 ‘‘dem-
onstrate 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
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
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(331) SIMPSON v. COMMISSIONER 345
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 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 regu-
lations and abandoned the ‘‘based upon tort or tort type
rights’’ requirement so long as recovery is for personal phys-
ical injuries or physical sickness even if recovery is under a
statute that does not provide for a broad range of tort rem-
edies. See sec. 1.104-(c), Income Tax Regs. 11
1996, Pub. L. No. 104–188, sec. 1605, 110 Stat. at 1838.
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 Janu-
ary 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:
Before the 1996 amendment, the section 104(a)(2) exclusion was not lim-
ited 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, Com-
missioner 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 leg-
islative and judicial developments have eliminated the need to base the
Continued
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346 141 UNITED STATES TAX COURT REPORTS (331)
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, 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 regula-
tions, and in the setting at hand we apply them as written. 13
In other words, under the applicable regulations, even if pay-
ments 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
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 tra-
ditional 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 ca-
pacity resulting from her work-related injuries. Gamble v. Workers’ Comp.
Appeals Bd., 143 Cal. App. 4th 71, 80 (Ct. App. 2006). Similarly, tem-
porary disability benefits under California laws, which formed the remain-
ing portion of Ms. Simpson’s settlement, seek to provide an injured em-
ployee interim wage replacement assistance during the period she is heal-
ing. 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 nar-
rowly and exclusively ‘‘ ‘legal injuries of an economic character’ ’’, Commis-
sioner 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 posi-
tion that the State has deemed she would have occupied absent the dis-
ability 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 fa-
vorable to petitioners, and we thus apply the regulations retroactively to
their benefit.
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(331) SIMPSON v. COMMISSIONER 347
excluded from gross income under section 104(a)(2) if the tax-
payer 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, 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’ com-
pensation 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, 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 tax-
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348 141 UNITED STATES TAX COURT REPORTS (331)
payer in connection with any action involving an unlawful
discrimination claim. See also sec. 62(e) (defining ‘‘unlaw-
ful 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
$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 tax-
payer 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 esti-
mate 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).
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,
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 judgment or settlement * * * resulting from * * * [an unlaw-
ful 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 discrimina-
tion suit. If none of the $250,000 was allocable to the unlawful discrimina-
tion suit and if Sears would not have entered into the settlement agree-
ment 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 re-
spondent has conceded this issue, we need not address it.
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(331) SIMPSON v. COMMISSIONER 349
Mr. Anton’s testimony shows that petitioners paid $38,014.40
in court costs and $113,985.60 in attorney’s fees. The settle-
ment 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 irrele-
vant, moot, or lacking in merit.
To reflect the foregoing,
Decision will be entered under Rule 155.
f
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