Damages Received by Customer Abused by Car Dealer Are Not Excluded From Income Under § 104(a)(2)

Following up on my prior post, Why Are We Bailing Out These Guys?: the Sixth Circuit yesterday affirmed the Tax Court (Stadnyk v. Commissioner, T.C. Memo. 2008-289 (Dec. 22, 2008)) in holding that $49,000 received by a customer abused by a car dealer after purchasing a used Geo Storm that broke down on the ride home from the lot is not excluded from income under § 104(a)(2). Stadnyk v. Commissioner, No. 09-1485 (6th Cir. Mar. 1, 2010):

On December 11, 1996, Petitioners purchased a used 1990 Geo Storm from Nicholasville Road Auto Sales, Inc. for $3,430.00. Brenda Stadnyk tendered two checks to Nicholasville Auto as partial payment, check number 1080 for $100 and check number 1087 for $1,100, from a checking account with Bank One. After Petitioners drove approximately seven miles from the dealership, the car broke down. Petitioners spent $479.78 to repair the car. They attempted to call Nicholasville Auto about the Geo Storm, but their calls were ignored, placed on hold for long periods of time, and not returned.

Because of their dissatisfaction with the car, Mrs. Stadnyk contacted Bank One to place a stop payment order on check number 1087 for $1,100. Bank One’s record of the stop payment order indicates “dissatisfied purchase” as the reason for the stop payment. However, Bank One incorrectly stamped the check “NSF” for insufficient funds and returned it to Nicholasville Auto. On February 4, 1997, Nicholasville Auto filed a criminal complaint against Mrs. Stadnyk for issuing and passing a worthless check in the amount of $1,100.

At approximately 6:00 p.m. on February 23, 1997, officers of the Fayette County Sheriff’s Department arrested Mrs. Stadnyk at her home in the presence of her husband, her daughter, and a family friend, and transported her to the Fayette County Detention Center. She arrived at the detention center at approximately 6:30 p.m., and she was handcuffed, photographed, and confined to a holding area. At approximately 11:00 p.m., Mrs. Stadnyk was transferred to Jessamine County Jail, where she was searched via pat-down and use of an electric wand. Mrs. Stadnyk was required to undress to her undergarments, remove her brassiere in the presence of officers, and put on an orange jumpsuit. She was released on bail at approximately 2:00 a.m. on February 24, 1997. On April 23, 1997, Mrs. Stadnyk was indicted for “theft by deception over $300.00” based on the returned check marked for insufficient funds. These charges were later dropped.

Mrs. Stadnyk testified that she did not suffer any physical injury as a result of her arrest and detention. ...   On August 25, 1999, Mrs. Stadnyk filed a Complaint against J.R. Maze, the owner of Nicholasville Auto, Nicholasville Auto, and Bank One. ...

On March 7, 2002, Mrs. Stadnyk entered into a mediation agreement with Bank One, under which Bank One agreed to pay Mrs. Stadnyk $49,000 to settle her claims and provide her with a letter of apology. In return, Mrs. Stadnyk agreed to dismiss her complaint against Bank One. ... The mediation agreement ... contained no language indicating the purpose for which the settlement was paid. On March 14, 2002, Bank One issued a check to Mrs. Stadnyk for $49,000, and on May 3, 2002, Mrs. Stadnyk’s complaint against Bank One was dismissed with prejudice. [Fn.1: Mrs. Stadnyk’s claims against J.R. Maze and Nicholasville Auto had already been dismissed with prejudice pursuant to an order entered on June 8, 2001. The record contains no information as to the terms of the dismissal.]

During the trial before the Tax Court, Mrs. Stadnyk testified that her attorney, the attorney for Bank One, and the mediator all advised her that the settlement proceeds would not be subject to income tax. Based on this advice, the Stadnyks did not report the $49,000 settlement on their 2002 Form 1040 income tax return, although Bank One issued Mrs. Stadnyk a Form 1099-MISC reporting the payment of the $49,000 settlement. On March 14, 2005, Respondent issued a notice of deficiency to Petitioners, after determining that Petitioners were liable for a tax deficiency of $13,119.00 and an accuracy-related penalty of $2,624.00 under § 6662(a). Petitioners timely appealed to the Tax Court. On January 12, 2009, the Tax Court ruled in favor of Respondent with respect to the deficiency and in favor of Petitioners with respect to the penalty. On April 15, 2009, Petitioners filed a timely notice of appeal. ...

Mrs. Stadnyk’s $49,000 settlement classifies as gross income under § 61(a), and Petitioners can only avoid paying taxes on the damages award if it falls under an exclusion.

The exclusion from § 61(a) at issue in the instant case is contained in § 104(a)(2), which permits taxpayers to exclude from income “the amount of any damages received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness.” The Supreme Court has held that a taxpayer must meet two independent requirements before a recovery may be excluded under § 104(a)(2). “First, the taxpayer must demonstrate that the underlying cause of action giving rise to the recovery is based upon tort or tort type rights; and second, the taxpayer must show that the damages were received on account of personal injuries or sickness.” Schleier, 515 U.S. at 337. ... Petitioners argue that their settlement award satisfies the two-part test laid out in Schleier, and, thus, may be excluded from taxation under § 104(a)(2).

Under the first prong, the question is whether Mrs. Stadnyk’s claims against Bank One giving rise to her recovery are based upon tort or tort type rights. ... We agree with the Tax Court’s analysis ...  that Mrs. Stadnyk’s settlement with Bank One was based on tort or tort type rights. Having satisfied the first prong, to obtain an exclusion under § 104(a)(2), Mrs. Stadnyk must show that she sustained the damages on account of personal physical injuries or sickness. ...

During her deposition, Mrs. Stadnyk testified that she did not suffer any physical injury as a result of her arrest and detention. ... The Tax Court correctly noted that “[t]he damages sought by [Mrs. Stadnyk] against Bank One are stated in terms of recovery for nonphysical personal injuries: [e]motional distress, mortification, humiliation, mental anguish, and damage to reputation.” These are all emotional injuries, and are thus not excludable under § 104(a)(2).

Petitioners’ only evidence arguably supporting the purpose necessary for exclusion under § 104(a)(2) is Mrs. Stadnyk’s testimony that her attorney, the attorney for Bank One, and the mediator all advised her that the settlement proceeds would not be subject to income tax. However, even assuming the attorneys did give her this advice, there is no evidence concerning the basis for the advice. ... Given that the settlement agreement included no indication that Bank One paid the settlement on account of any physical injury and that all of Mrs. Stadnyk’s damages were stated in terms of emotional distress, Petitioners have failed to offer any concrete evidence demonstrating a causal connection between any physical injury and the settlement award. Thus, Petitioner’s settlement award may not be excluded from taxation under § 104(a)(2). ...

Petitioners argue that § 104(a)(2) ... violates the Sixteenth Amendment to any extent that it purports to subject compensation for personal injuries to income tax. ... Even if the Court were to find that the damages award is not income within the meaning of § 61(a) and the Sixteenth Amendment, a tax on Mrs. Stadnyk’s settlement award would only be unconstitutional if it were a direct tax requiring apportionment or not uniform. ... The tax on Petitioner’s damages award is not a direct tax. Only three taxes are definitively known to be direct: (1) a capitation, (2) a tax upon real property, and (3) a tax upon personal property. See Murphy, 493 F.3d at 181. However, a tax on damages sustained on account of personal injury is not a tax on property; rather, it is a tax on the receipt of a damages award. ... Thus, it need not be apportioned. ... Moreover, so long as Congress has the power to levy the tax, it is irrelevant whether it was proper for the tax to be labeled income tax or collected pursuant to § 61(a). ... Finally, even assuming the tax in this case is an excise subject to the uniformity requirement, the tax in this case meets this standard. Thus, the Tax Court did not err by concluding that § 104(a)(2) does not violate the Constitution.