Is "equitable remedy" settlement excludable from gross income?

Taxpayers are continually testing the legal definitions of "personal physical injuries" and "physical sickness." The Tax Court recently decided an "equitable remedy" settlement did not meet the criteria for the tax treatment afforded these conditions.

In 1985 William Kidd filed a lawsuit against the state of California, its personnel board and its fish and game department, asserting the state's affirmative action policy of "supplemental certification" violated his rights under the Equal Protection Clause of the 14th Amendment to the U. S. Constitution and the "merit" principle in the California constitution. Kidd had applied for positions with the fish and game department; it filled these positions, through a supplemental certification program, with individuals who had not performed as well as he had on competitive examinations. Kidd did not seek monetary damages; rather he sought to have the program stopped and employees hired under it dismissed.

While the lawsuit was pending in superior court, the state personnel board reexamined the supplemental certification program and concluded it was improper. The superior court dismissed Kidd's lawsuit. The court of appeals reversed and remanded that decision with instructions to "fashion an equitable remedy to redress the violation of plaintiff's constitutional and statutory rights." In 2000 Kidd received a $132,000 settlement from the state of California. He did not include the sum on his 2000 federal income tax return. The IRS concluded he should have included the payment as income and filed a deficiency notice of $43,012.

Result. For the IRS. Kidd argued the state had awarded the payment to him for injuries unrelated to traditional work-related compensation, such as back pay or a lost job opportunity. He further asserted the $132,000 compensated him for the "abuse and mental distress" he had suffered as a result of the state's treatment of him.

The Tax Court rejected these arguments. Since the settlement did not expressly state the reason for the payment, the court looked to the two-pronged test in IRC section 104(a)(2): (1) The underlying cause of action must be based upon tort or tort-type rights and (2) the payment must be on account of personal physical injuries or physical sickness. The court concluded the abuse and mental distress met neither the definition of personal physical injuries or physical sickness nor the emotional distress exception in section 104(a).

Kidd was one of a series of cases testing the definition of personal physical injuries or physical sickness. With the recently filed discrimination case against Wal-Mart, CPAs can expect such tests to continue.

* William L. and Marsha G. Kidd v. Commissioner, TC Memo 2001-135.