Lesson From The Tax Court: An 'Origin of the Claim' Test For §104(a)(2) Exclusions

Here at Texas Tech we require all law students to take the basic course in federal income tax. That is not because we are especially cruel, but rather because tax law touches so many other areas of practice that the faculty believes every student should have an introduction to tax. I must shape my course knowing that at least two thirds of the students do not want to become tax lawyers. One tack I take is to highlight tax issues that regularly come up in other practice areas such as family law and litigation.

A case from the Tax Court last week teaches a useful lesson about the intersection of tax with litigation practice.  Jacques L. French and Sherry L. French v. Commissioner, T.C. Summary Op. 2018-36 (July 12, 2018) involves taxpayers seeking to exclude a settlement payment under §104(a)(2), the section that allows taxpayers to exclude from gross income the amount of damages received because of personal physical injury or physical illness.

We usually think about the “origin of the claim” test in the §162 context, where courts use it to decide when taxpayers may deduct expenses associated with litigation. In fact, just this last week I saw another Tax Court opinion that involves this application of the origin of the claim test. I may blog that next week, unless something else catches my eye.

This week, however, I think it is useful to see how the Tax Court takes a very similar approach to deciding when a taxpayer can exclude a damage award under §104(a)(2). In both situations, it is the nature of the claim asserted in litigation that governs the potential exclusion or the potential deduction.  Looking at §104(a)(2) also allows me to give a shout out to the Tax Court's newest Special Trial Judge, Diana L. Leyden.  Her carefully constructed opinion shows us exactly how the Tax Court applies this “origin of the claim test” in the §104(a)(2) context. It makes for a nice lesson from the Tax Court.

The Law

Section 104(a)(2) permits taxpayers to exclude from gross income the amount of any damages received on account of personal physical injury (except punitive damages). The flush language of §104(a), however, instructs taxpayers that emotional distress standing alone is not personal physical injury for purposes of the exclusion, so damages received for emotional distress are not excludable (except to the extent that taxpayers recover the medical costs incurred to treat the emotional distress).

Causality is crucial to establish the §104(a)(2) exclusion. A taxpayer must show “a direct causal link between the damages and the personal injuries or physical sickness sustained.” Lindsey v. Commissioner, 422 F.3d 684 (2005) (8th Cir. 2005). It is not enough that some physical sickness is present in the facts of the case.  After all, emotional distress can cause physical manifestations, such as TMJ.  In the Lindsey case, for example, the taxpayer had sued his former firm for tortious interference with contracts.  At trial his doctor testified that during the tortious events (occurring over a period of two years) Mr. Lindsey suffered from hypertension and stress-related symptoms, including periodic impotency, insomnia, fatigue, occasional indigestion, and urinary incontinence.  But that was not the right causal direction.  Said the Eighth Circuit: “We agree with the Tax Court that these health symptoms relate to emotional distress, and not to physical sickness.”  So the taxpayer was not allowed to exclude the settlement payments.

In figuring out whether the taxpayers had established the requisite causality, the Tax Court tells us that “the pertinent analysis entail a consideration of extrinsic factors informative of the nature of the underlying claims.... Relevant extrinsic factors include the details surrounding the litigation, the allegations contained in the complaint and the course of the settlement negotiations between the parties.” Goode v. Commissioner, T.C. Memo 2006-48 (March 21, 2006).

In other words, the Tax Court will look at (1) the pleadings, (2) the negotiations, and (3) the actual settlement document (or jury verdict) to see what part, if any, of the damage award or settlement payment is received on account of personal physical injury or sickness.

The Case

The French case shows how the Court evaluates those factors. There, Mr. and Mrs. French picked a bad time to buy a home in a beautiful place: Rockingham County, Virginia. They closed their loan in July 2008, just a few months before the Lehman Brother’s bankruptcy really got the Great Recession receding. In late 2009 they tried to re-negotiate their mortgage and got cross-wise with the Bank of America and its servicer BAC Home Loans Servicing. As a result, they received harassing phone calls well into January 2010. Mrs. French was in poor health and under doctor’s orders to avoid stress. The repeated phone calls were stressful. During this time period she experienced two pulmonary emboli, had to be resuscitated twice, and was placed in a medically induced coma. She was discharged from the hospital in February 2010. After that, as Judge Leyden notes, it does not appear from the record that Mrs. French encountered further medical difficulties.

But the Frenches’ mortgage difficulties did not abate and about 18 months later, in November 2011, the Frenches filed a state court lawsuit against Bank of America and BAC. The parties eventually settled and in 2012 (the year at issue) Bank of America made two payments totaling $62,000: (1) two thirds ($40,333) to Mr. and Mrs. French; and (2) one-third ($21,666) to their attorney. Raise your hand if you think the attorney had taken the case on a contingency fee basis.

The Frenches did not report any of the $62,000 as income.  On audit the IRS issued an NOD for underreported income of---hold on to your seat---$41,333!  Yep.  No mention of the $21,666!  Come on guys, this is now 13 years since the Supreme Court said “We hold that, as a general rule, when a litigant's recovery constitutes income, the litigant's income includes the portion of the recovery paid to the attorney as a contingent fee.” Commissioner v. Banks, 543 U.S. 426, 430 (2005).  Perhaps I am missing something, but my guess is that the IRS picked up only the $41,333 because that is what Bank of America put on its Form 1099-MISC.  Presumably it also sent the attorney a Form 1099-MISC for the $21,666.  

So do we praise the Frenches’ state court attorney for structuring the payments so that form triumphs over substance?  Was this a deliberate work-around to the Banks case? Nah. My guess is that the attorney just chose that payment method out of convenience. It meant fewer transactions in the trust account, without risking nonpayment of fees. I think that because if the state court attorney had really been thinking of federal tax consequences, he would have done a much better job in framing the litigation to link it to Mrs. French’s physical condition.

Here is how Judge Leyden applied the law to determine if the nature of the claim made the settlement payments “on account of physical injury.”

She first looked at the Complaint. The Complaint alleged a bunch of stuff: fraud, conversion, breach of federal law governing settlements. It asked for punitive damages and equitable relief. However, as Judge Leyden notes: “The complaint did not seek any relief for personal physical injuries or physical sickness with respect to Mrs. French.”  That seems a surprising omission from the Complaint.  If Mrs. French had been near death in the hospital because of the harassing phone calls, you would think the state court attorney would have put that in the Complaint. The state court attorney actually testified at trial that he left out that stuff for a variety of reasons, none of which Judge Leyden found convincing. But one has to admire the taxpayer’s tax attorneys, Michele Drumbl of the Washington and Lee School of Law Tax Clinic and her student Roland Hartung, for their thoroughness and thoughtfulness in trying to deal with the absence of physical injury language in the complaint.

Judge Leyden next looked at the settlement negotiations. Here, at least, was some mention of Mrs. French’s medical conditions in a letter from the state court attorney. The only problem was that the letter actually admitted that “Mrs. French’s initial injury was not caused by [Bank of America] and alleged only that the Bank’s actions caused both Mr. and Mrs. French “a tremendous amount of stress.” That’s not good enough. It’s like the Lindsey case above: the causality runs in the wrong direction. Defendant-causes-stress-and-stress-causes-physical- symptoms is the not causality you need. You need defendant-causes-physical-symptoms-causes-stress.

Finally, Judge Leyden looked at the settlement document itself. It contained nothing that allowed her to say any portion of the $41,333 paid to the Frenches was on account of physical injury.

So after looking at (1) the Complaint; (2) the negotiations leading to the settlement; and (3) the settlement document itself, Judge Leyden concluded that the Frenches could not exclude the $41,333.  That was the bad news.  But, again, the good news was the great windfall the Frenches received by not having to report as gross income the entire $62,000!

Coda: I tell my students that the legal distinction between “emotional” and “physical” damages is more and more problematic what with the changing medical understanding of the physiology of the brain.  Stress causes measurable physical damage to the brain.  So any one of my students may be the first lawyer to persuade a court that injuries traditionally dumped in the “emotional” box should really go in the “physical” box.  If you are looking for more on that, a good start is Betsy J. Grey, The Future of Emotional Harm, 83 Fordham L. Rev. 2605 (2015).

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law