A taxpayer could not exclude emotional- distress damages from gross income under Sec. 104 after being terminated from his employment at a midwestern university, the Tax Court held.

Facts: Bryant Tillman-Kelly was hired as project director in September 2009 to oversee and manage a federal grant the university received. In his position, he reported directly to a dean and the dean’s executive assistant. A few months later, Tillman-Kelly expressed concerns to the U.S. Department of Education and the university’s ethics office that “certain grant funds were being misappropriated.” In June 2010, the university terminated Tillman-Kelly’s employment.

After his termination, Tillman- Kelly filed suit against the university and its board of trustees, ultimately in Illinois state court, alleging that the university retaliated against him for his whistleblower complaint. He stated in the complaint that he was subjected to “humiliation, isolation, harsher discipline, and different and comparatively more negative terms and standards of employment” than other university employees. Tillman-Kelly also asserted that his supervisor threatened to “do what he had to do” in response to the whistleblower allegation, which, according to Tillman-Kelly’s complaint, included his job responsibilities being eliminated. Nowhere within the complaint did Tillman-Kelly allege that he suffered any physical injuries or sought damages for them. In Tillman- Kelly’s responses to interrogatories in the state court action, he stated that the dean’s assistant slammed a door on him, causing an injury. However, he did not describe the injury further or mention it in another interrogatory asking for the basis of his damages claim.

Tillman-Kelly settled his suit with the university in 2017. The settlement agreement specifically stated that the payment was for “alleged non-wage injuries, as non-economic emotional distress damages.” The university reported the payment to the IRS on Form 1099-MISC, Miscellaneous Income, which Tillman-Kelly and his wife did not report as gross income on their 2017 federal income tax return.

The IRS issued the Tillman-Kellys a deficiency notice claiming that the settlement payment should have been included in gross income.

Issues: Settlement proceeds received from a legal proceeding constitute gross income unless a specific statutory exception applies (see Save, T.C. Memo. 2009-209). Sec. 104(a)(2) states that damages awarded as part of a settlement or judgment can be excluded from gross income if they are “on account of personal physical injuries or physical sickness.”

Emotional distress is not itself treated as a personal physical injury or physical sickness for this purpose under Sec. 104(a). However, damages for emotional distress may be excluded from gross income if the distress is “attributable to a personal physical injury or physical sickness” (Regs. Sec. 1.104-1(c)(1); see also Rivera v. Baker West, Inc., 430 F.3d 1253 (9th Cir. 2005)). For this exclusion to apply, there must be a “direct causal link” between the damages awarded and the personal physical injury or physical sickness (Doyle, T.C. Memo. 2019-8, quoting Rivera, 430 F.3d at 1257).

When damages are received pursuant to a settlement agreement, the Supreme Court held in Burke, 504 U.S. 229, 237 (1992), “the nature of the claim that was the actual basis for the settlement controls whether the damages are excludable under Sec. 104(a) (2).” The nature of the claim is determined from the “underlying agreement” and, if it is unstated there, the payer’s intent is considered by looking at all the facts and circumstances surrounding the agreement, such as “the amount paid, the allegations in the injured party’s complaint, and the factual circumstances that led to the agreement” (Rivera, 430 F.3d at 1257). The character of the payment is based on the payer’s “dominant reason” for making the payment (see Green, 507 F.3d 857, 868 (5th Cir. 2007)).

Holding: The Tax Court held that the settlement agreement between Tillman-Kelly and the university established that the settlement amount was not excludable from gross income as a personal physical injury or physical sickness under Sec. 104(a)(2). The court found that the settlement amount was really a payment for “non-wage injuries, as non-economic emotional distress damages,” as stated in the text of the settlement agreement. Further, the court did not find any intent of the payer to characterize the payment as arising from a personal physical injury, which was made clear by all the facts and circumstances surrounding the initial complaint and settlement agreement.

The court rejected Tillman-Kelly’s claim that the settlement represented a payment for a personal physical injury from the slammed door, noting that it was not mentioned in the settlement agreement as a cause of damages.

Even if it were to look past the plain language of the settlement agreement, the Tax Court concluded, Tillman-Kelly “would fare no better.” It found that Tillman-Kelly’s complaint in his state court case did not relate to compensation for physical injuries. Rather, it alleged that the university violated the Illinois state whistleblower statute by taking retaliatory actions against Tillman-Kelly “involving improper removal of job responsibilities and ultimately termination, not physical injury.” Moreover, his complaint did not seek damages for physical injury, instead pursuing damages for “emotional distress and humiliation and lost income and benefits.”

As a result, the court sustained the IRS’s deficiency notice.