On February 18, 2021, the Tax Court issued a Memorandum Opinion in the case of Blum v. Commissioner (T.C. Memo. 2021-18). The primary issue presented in Blum was whether the petitioner was entitled to exclude from her gross income the $125,000 settlement payment (from a suit against former attorneys who bungled a personal injury lawsuit on petitioner’s behalf) as damages received “on account of personal physical injuries or physical sickness” under IRC § 104(a)(2).
The petitioner went to hospital for knee replacement. She was told to sit in a wheelchair, which turned out to be broken. When the petitioner sat in a wheelchair, she fell, sustaining “significant injuries.” The petitioner hired an attorney who sued the hospital for negligence, and when he retired in the middle of her case, she retained another attorney from the same firm to continue the case. However, the trial court granted summary judgment to the hospital. The petitioner appealed pro se but lost. In 2014, the petitioner brought a malpractice suit against her former attorneys, alleging that they had breached their duty of care in failing to properly prosecute her lawsuit against the hospital.
Critically, in her complaint, the petitioner alleged that her physical injuries were caused “solely by the negligence and/or fault of the hospital and its employees” and that she “would have prevailed in her claim against the hospital but for her former attorneys’ breach of the standard of care.” She did not allege in her complaint that she had suffered any physical injuries for which her former attorneys should be responsible, nor did she seek compensation for any physical injuries.
The parties settled for hundred and $125,000, and the settlement documents described the dispute between the parties as a “malpractice claim.” Further, the settlement documents make clear that the petitioner “did not sustain any physical injuries as a result of the alleged negligence of either of her former attorneys” and that the petitioner’s “physical injuries are alleged to have resulted from the hospital incident, which did not occur as a result of any fault or negligence by her former attorneys.”
Not unsurprisingly, the petitioner did not report the $125,000 settlement on her 2015 federal income tax return. When the IRS received a Form 1099-MISC from the attorneys’ insurance company, reporting the $125,000 payment, the IRS selected the petitioner’s return for examination and determined that the payment should have been included in her gross income.
Burden of Proof in Cases of Unreported Income
The IRS’s determinations in a notice of deficiency are generally presumed correct, and the taxpayer bears the burden of proving those determinations erroneous. See Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933); Merkel v. Commissioner, 192 F.3d 844, 852 (9th Cir. 1999), aff’g 109 T.C. 463 (1997). The IRS must establish “some evidentiary foundation” linking the taxpayer to an alleged income-producing activity before the presumption of correctness attaches to the deficiency determination. Weimerskirch v. Commissioner, 596 F.2d 358, 361-362 (9th Cir. 1979), rev’g 67 T.C. 672 (1977). Once the IRS has established such a foundation, the burden of proof shifts to the taxpayer to prove that she is entitled to an exclusion from gross income. See Simpson v. Commissioner, 141 T.C. 331, 338-339 (2013), aff’d, 668 F. App’x 241 (9th Cir. 2016). The petitioner has not contended, and the record does not show, that the burden of proof should shift to IRS under IRC § 7491(a).
Settlement Proceeds as Gross Income
Exclusions from gross income must be narrowly construed. Commissioner v. Schleier, 515 U.S. 323, 328 (1995); United States v. Burke, 504 U.S. 229, 248 (1992). Settlement proceeds constitute gross income unless the taxpayer proves that they fall within a specific statutory exception. See id. at 328-337; Save v. Commissioner, T.C. Memo. 2009-209, *1. IRC § 104(a)(2) supplies one such exception, excluding from gross income any damages other than punitive damages received whether by suit or agreement on account of personal physical injuries or physical sickness. For a taxpayer to fall within this exclusion, he must show that there is a direct causal link between the damages and the personal injuries sustained. Doyle v. Commissioner, T.C. Memo. 2019-8, at *11 (quoting Rivera v. Baker W., Inc., 430 F.3d 1253, 1257 (9th Cir. 2005)). When damages are received pursuant to a settlement agreement, the nature of the claim that was the actual basis for the settlement controls whether the damages are excludable under IRC § 104(a)(2). See Burke, 504 U.S. at 237; see also Bagley v. Commissioner, 105 T.C. 396, 406 (1995) (“[T]he critical question is, in lieu of what was the settlement amount paid[?]”), aff’d, 121 F.3d 393 (8th Cir. 1997); Smith v. Commissioner, T.C. Memo. 2018-127, at *18.
The nature of the claim is typically determined by reference to the terms of the agreement. See Rivera, 430 F.3d at 1257. Thus, when damages are paid through a settlement agreement, the Tax Court looks first to the underlying agreement to determine whether it expressly states that the damages compensate for ‘personal physical injuries or physical sickness’ under IRC § 104(a)(2). Id.; Ghadiri-Asli v. Commissioner, T.C. Memo. 2019-142, at *38. If an agreement fails to answer the question, the Tax Court looks primarily to the intent of the payor. Devine v. Commissioner, T.C. Memo. 2017-111, at *11 (quoting Longoria v. Commissioner, T.C. Memo. 2009-162; see also Rivera, 430 F.3d at 1257; Knuckles v. Commissioner, 349 F.2d 610, 613 (10th Cir. 1965), aff’g T.C. Memo. 1964-33; Ahmed v. Commissioner, T.C. Memo. 2011-295, *3, aff’d, 498 F. App’x 919 (11th Cir. 2012).
The intent of the payor may be determined by taking into consideration, inter alia, the amount paid, the factual circumstances leading to the settlement, and the allegations in the injured party’s complaint. See Green v. Commissioner, 507 F.3d 857, 868 (5th Cir. 2007), aff’g T.C. Memo. 2005-250; see also Rivera, 430 F.3d at 1257; Bent v. Commissioner, 87 T.C. 236, 245 (1986), aff’d, 835 F.2d 67 (3d Cir. 1987). The nature of underlying claims cannot be determined from a general release of claims that is broad and inclusive. Ahmed, T.C. Memo. 2011-295, at *3.
The Nature of the Settlement Payment
The Tax Court looks no further than the parties’ settlement agreement to conclude that the settlement payment is not excludable under IRC § 104(a)(2). The parties expressly identified the suit as a malpractice claim and specified that they entered into the agreement for the purpose of compromising and settling the disputes. The agreement further emphasized that the settlement did not compensate for any personal injuries. The agreement thus makes clear that the payment was in lieu of damages for legal malpractice and not “on account of personal physical injuries or physical sickness” within the scope of IRC § 104(a)(2).
Return of Capital Argument
The petitioner counters that the payment was received on account of personal physical injuries or physical sickness, because “but for her attorneys’ negligent representation,” she would have received damages from the hospital that would have been excludable under IRC § 104(a)(2). To this end, the petitioner argues that the Tax Court should expand the “return of capital exclusion” to cover this case.
Generally, recovery of capital is not income. See United States v. Safety Car Heating & Lighting Co., 297 U.S. 88, 98 (1936). Whether a payment received in settlement of a claim represents a replacement of capital depends on the nature of the claim that was the actual basis for the settlement. See Spangler v. Commissioner, 323 F.2d 913, 916 (9th Cir. 1963), aff’g T.C. Memo. 1961-341. The Tax Court has held previously that “an amount paid to a taxpayer in order to compensate the taxpayer for a loss that the taxpayer suffered because of the erroneous advice of the taxpayer’s tax consultant generally is a return of capital and is not includible in the taxpayer’s income.” Cosentino v. Commissioner, T.C. Memo. 2014-186, at *31; see also Clark v. Commissioner, 40 B.T.A. 333, 335 (1939); Concord Instruments Corp. v. Commissioner, T.C. Memo. 1994-248, *24-*25.
The petitioner asserts that the settlement payment here represents a similar return of capital in that it compensated her for a loss that she suffered because of the erroneous advice of her lawyers, viz, the nontaxable amount she would have received had she prevailed in her personal injury lawsuit. The petitioner claims that the settlement is an implicit acknowledgement by the attorneys that she would have prevailed in her personal injury lawsuit were it not for their malpractice.
The Tax Court has its doubts.
As an initial matter, the Tax Court was not convinced that the petitioner experienced a “loss” at all. The purported loss that she claims was the amount that she might have received from winning her personal injury lawsuit, which struck the Tax Court as a highly speculative proposition. Moreover, the petitioner failed to convince the Tax Court that the settlement payment was meant to replace this purported loss, rather than for any of the other reasons that might have prompted her former attorneys to settle.
In short, the Tax Court did not view her recovery in the malpractice case as restoring her capital but instead as compensating her for distinct failings by her former lawyers. Consequently, this amount is not a recovery of capital and is includable in her gross income.
Moral of the story – Under IRC § 104(a)(2), a settlement is excludible from income if it arises out of a personal injury; however, the settlement you get from suing your attorney for failing to secure a personal injury judgment does not arise out of the personal injury, no matter how much you might want it to. Even if you want it really, really badly.
Footnote re Mr. Knuckles:
 Unless this is a nom de guerre, in which case this would be my new favorite Tax Court case name, what an absolutely unfortunate last name.Add to favorites