Tax Court in Brief | Dern v. Comm’r | Direct Causation a Must to Exclude from Income Damages for Injury or Sickness, Section 104(a)(2)

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Tax Litigation:  The Week of August 29th, 2022, through September 2nd, 2022

Dern v. Comm’r, T.C. Memo. 2022-90| August 30, 2022 | Vasquez, J. | Dkt. No. 7595-20

Short Summary:

In this memorandum opinion, the Tax Court set forth its ruling based on its view of the relevant facts and points of law after holding a remote trial. The Petitioner, Thomas Dern, received a settlement in connection with a suit against his former employer. He did not report the amount he received as income or pay taxes on the amount. The IRS determined a deficiency of just under $100,000.00. Mr. Dern was a commissions-based sales representative who worked for a single manufacturer as an independent contractor. As a result of serious acute gastrointestinal bleeding and a resulting heart attack in September 2017, Mr. Dern missed a few months of work, then resumed duties working only from home in December and January. The employer asked him to resume in-person sales calls in January. He continued working only remotely. The employer then terminated Dern’s sales representative agreement at the end of the month.

Dern then sued the company under California law for misclassification of employment status, wrongful termination, failure to pay wages, breach of contract, intentional infliction of emotional distress, failure to take all reasonable steps to prevent discrimination, and for several violations of the California Fair Employment and Housing Act. Those violations included disability discrimination, failure to accommodate disability, age discrimination and failure to engage in the interactive process required by that Act. Eventually, the parties entered a written settlement agreement. The employer agreed “to compensate [Mr. Dern] for alleged personal injuries, costs, penalties, and all other damages and claims.” In addition to a general release, the agreement contained a statement that the payment was “for and on account of [Mr. Dern’s] claims alleging compensatory damages, emotional injuries, penalties, and punitive damages.”

Key Issue:

Dern argued that the illness led to his firing and that, consequently, the settlement payment qualified as non-taxable income. The Court analyzed whether Dern’s settlement payment qualified for the exclusion from gross income established in IRC section 104(a)(2) for “damages (other than punitive damages) received […] on account of personal physical injuries or physical sickness.”

Primary Holding:

The entire amount Dern received was taxable income as it was not compensation for physical sickness or injury. In the lawsuit, Dern never asserted he became ill as a result of his work. In fact, he admitted the illness was unrelated. Accordingly, the employer did not compensate Dern for any sickness or injury. Because there was not a direct causal link between the payment and the physical injury, the payment did not qualify for the section 104(a)(2) exclusion.

Key Points of Law:

  • Determinations in a notice of deficiency are generally presumed correct, and the taxpayer bears the burden of proving them erroneous. 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).
  • In the 9th Circuit, in a case for failure to report income the Commissioner must first establish “some evidentiary foundation” linking the taxpayer to an alleged income-producing activity before an IRS determination is presumed correct. Weimerskirch v. Commissioner, 596 F.2d 358, 361–62 (9th Cir. 1979), rev’g 67 T.C. 672 (1977). After the foundation is established, the taxpayer has the burden of proving the determination is arbitrary or erroneous. See Hardy v. Commissioner, 181 F.3d 1002, 1004–05 (9th Cir. 1999), aff’g T.C. Memo. 1997-97.
  • Gross income includes all income from any source and statutory exclusions from gross income are narrowly construed; petitioners have the burden to clearly establish the application of any alleged exclusion. See Commissioner v. Schleier, 515 U.S. 323, 328, 336-37 (1995); United States v. Burke, 504 U.S. 229, 233-234 (1992).
  • Without a written statement specifying what type of legal harm the settlement proceeds were intended to compensate, the Tax Court determines the intent of the payor based on the facts and circumstances of this case. See Knuckles v. Commissioner, 349 F.2d 610, 613 (10th Cir. 1965), aff’g T.C. Memo. 1964-33.
  • To qualify for the section 104(a)(2) exclusion, there must be a “direct causal link” between the payment and the physical injury or illness. See Lindsey v. Commissioner, 422 F.3d at 688. (8th Cir. 2005), aff’g T.C. Memo. 2004-113.
  • Because the Tax Court is not a court of equity, it cannot ignore the law to achieve an equitable result. See Commissioner v. McCoy, 484 U.S. 3, 7 (1987); Stovall v. Commissioner, 101 T.C. 140, 149–50 (1993); Paxman v. Commissioner, 50 T.C. 567, 576–77 (1968), aff’d, 414 F.2d 265 (10th Cir. 1969).


  • When settling cases involving employment disputes, especially when they involve misclassified employees, employers, employees and their counsel should pay close attention to the tax consequences that attach to settlement payments.
  • The IRS originally asserted that Dern failed to pay self-employment tax. But prior to trial, the Commissioner conceded this point. This was likely a result of Dern’s misclassification as an independent contractor. Presumably, the payment included amounts deemed wages under the Code. The IRS may have sought to recover these amounts from Dern’s employer. As an underlying point for employers, FICA is owed on all payments made by an employer to an employee. Further, all wages are subject to withholding. This includes all compensation rendered as the result of a judgment or settlement and includes both backpay and front pay (however, the 5th Circuit does not treat front pay as wages, see Doston v. U.S., 87 F.3d 682 (5th Cir. 1996)).

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