Lawsuit proceeds includible in income

Editor: Mark G. Cook, CPA, CGMA

In April 2024, the Tax Court reiterated in Estate of Finnegan, T.C. Memo. 2024-42, that lawsuit damages are generally not excludable from gross income if a taxpayer does not receive them on account of physical injury or physical sickness.

Background

The taxpayers, members of the Finnegan family, who resided in Indiana, sought to exclude from their gross income a substantial lawsuit settlement they won in 2017. They asserted that the damages they received in the settlement were paid on account of post-traumatic stress disorder (PTSD) that was caused by the actions of the lawsuit’s defendants. They further asserted that PTSD is a form of physical injury, and thus the damages were excludable under Sec. 104(a)(2) as damages received on account of personal physical injuries.

A 14-year-old member of the Finnegan family died in 2005. The Pulaski County, Ind., Department of Child Services (DCS) and the Indiana State Police investigated the death, and the police arrested Roman Finnegan and his wife, Lynnette, the teen’s mother, on charges of medical neglect. The criminal charges were ultimately dismissed, and the Finnegans were not convicted of any criminal wrongdoing related to the death. DCS continued investigating after the charges were dismissed, which kept the Finnegans on Indiana’s child protection index and led to the removal of two other children from their care. In 2010, the Pulaski Circuit Court ordered DCS to immediately unsubstantiate the various complaints and remove the Finnegans from the child protection index.

The Finnegans claimed that the actions taken by DCS were retaliatory due to complaints they had raised about the behavior of a certain caseworker. They claimed that multiple officials retaliated by creating false substantiations of medical neglect, illegally detaining their children, and making claims of abuse unsupported by evidence. The Finnegans brought suit in federal district court against a number of employees of Indiana for alleged violations of their civil rights under state law, federal law, and the First, Fourth, Sixth, and Fourteenth Amendments to the U.S. Constitution. These alleged violations related to the Finnegans’ right to petition the government, illegal seizure of property, their right to counsel, and their right to due process. Notably, none of the Finnegan family members involved in the original suit alleged that they had developed PTSD or any other physical injury or physical sickness as a result of the defendants’ actions.

The Finnegans were awarded $31.35 million in compensatory damages for the violation of their rights, but the jury did not state that any damages were awarded to any of the Finnegans for the development of PTSD or any other physical injury or physical sickness. The Finnegans ultimately settled their claims for $25 million in 2017.

Tax returns and Tax Court proceedings

On tax returns Roman and Lynette Finnegan filed for 2017, they did not include the settlement proceeds they received in gross income. In 2018, the IRS initiated an examination of their return; later, the IRS included in its examination the returns of the other family members who received payments from the settlement.

During the examination, the Finnegan family members took the position that the damages they received from the settlement were on account of PTSD and therefore excludable under Sec. 104(a)(2). Under this section, an exclusion from gross income is allowed for damages received “on account of personal physical injuries or physical sickness.” Damages unrelated to physical injury or physical sickness are generally taxable under Sec. 61.

The IRS determined that Sec. 104(a)(2) did not apply and the compensation received from the lawsuit was fully taxable for all of the Finnegans. The Service issued the various family members notices of deficiency.

The Finnegans challenged the IRS’s determination in Tax Court, and all of the family members’ cases were consolidated into one proceeding.

The Tax Court’s holding

The Tax Court held that the settlement proceeds were not paid on account of personal physical injuries or physical sickness and thus were not excludable from any of the Finnegans’ gross income under Sec. 104(a)(2).

As the Supreme Court has held, when damages are received pursuant to a settlement agreement, the nature of the claim that gave rise to the settlement controls whether the damages are excludable under Sec. 104(a)(2) (Burke, 504 U.S. 229, 237 (1992)). To determine the nature of the claim, the Tax Court found it should look at the terms of the settlement agreement and, if its terms were ambiguous, to the facts and circumstances surrounding the settlement.

As the Tax Court observed, the settlement agreement provided that the payment was a settlement of the Finnegans’ claims for alleged violations of federal laws, state laws, the Finnegans’ civil and constitutional rights, and any other claims arising from their lawsuit. Notably, it made no reference to PTSD, physical injury, or physical sickness. Therefore, even if the court accepted the Finnegans’ argument that PTSD was a physical injury that would support income exclusion under Sec. 104(a)(2), it determined that, on the basis of the settlement agreement, the damages the Finnegans received were not on account of PTSD or any physical injury or physical sickness.

Moreover, the Tax Court found that if it looked outside the settlement agreement, the Finnegans “would fare no better.” Both the Finnegans’ original and amended complaints did not seek damages for PTSD, and the jury instructions also did not mention PTSD or physical injury or sickness. The only mention of PTSD in the lawsuit was in one paragraph of Roman Finnegan’s 53-paragraph narrative statement in response to an interrogatory describing the damages he suffered due to the defendants’ actions. In that paragraph, he stated, “When I first went back to work, there were days that I could not get out of bed. I had attacks in which I couldn’t breathe. I thought they were heart attacks but they were diagnosed as post-traumatic stress syndrome.”

Thus, as the Tax Court stated, “[w]ith the vast ocean of evidence before us concerning the district court litigation, references to PTSD make barely a drop in the bucket. Rather, the image that overwhelmingly emerges is that the damages were paid not as compensation for PTSD but for violations of plaintiffs’ constitutional rights stemming from defendants’ conduct and the emotional pain caused therefrom.”

As a result, the Tax Court held that Sec. 104(a)(2) did not apply and the full amount of settlement proceeds was includible in gross income and subject to tax. Because the settlement agreement did not award damages for the Finnegans’ alleged PTSD, the Tax Court did not determine whether PTSD qualifies as a “physical illness” under Sec. 104(a)(2).

Unexpected tax consequences

Legal awards often result in unexpected and unintended financial and tax consequences for recipients. Between the taxability of gross proceeds without a reduction for legal fees incurred (see Banks, 543 U.S. 426 (2005)) and the temporary elimination by the Tax Cuts and Jobs Act, P.L. 115-97, of miscellaneous itemized deductions, recipients of lawsuit damages often retain far less post-tax cash than they are initially awarded or receive in a settlement.

For example, a single taxpayer in California awarded $5 million in damages could walk away with less than $600,000 after paying a 40% nondeductible contingent legal fee and federal and state taxes on the gross settlement. However, where damages are awarded for physical injury or illness, they may be excludable from tax, resulting in a $3 million takeaway for the recipient under the same facts.

Estate of Finnegan shows the importance of proving and clearly including physical damages in a lawsuit if the damages are to be excludable From gross income under Sec. 104(a) (2) , whether the damages are awarded through trial or in a settlement. In a settlement agreement, damages should be itemized with a dollar value assigned to each harm so if they are received for physical injury or physical illness, they are clearly separated and can be excluded from income tax where appropriate. To withstand IRS scrutiny, any surrounding documents should be clearly drawn up to support the position that damages are excludable.

Editor Notes

Mark G. Cook, CPA, CGMA, MBA, is the lead tax partner with SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact Cook at mcook@singerlewak.com.

Contributors are members of or associated with SingerLewak LLP.