Tax Byte
When is a Settlement Partially Excludable? Tax Court Draws the Line (Joseph J. Zajac, III v. Comm., (TCM 2025-33))
Joseph Zajac received a $35,001 settlement payment from the Town of Bolton related to claims arising from his arrest and incarceration on May 1, 2004. The settlement agreement was notably vague, simply referring to payment for “the accident, casualty or event which occurred on or about May 1, 2004[,] at or near Bolton, MA” without further context.
Prior to the settlement, Zajac had sent a claim letter to the Town of Bolton alleging:
- Physical injuries including cuts and bruises resulting from excessive force during his arrest
- Exacerbation of preexisting lower back and knee conditions caused by the force used during arrest and the conditions during incarceration
- Emotional distress associated with these physical injuries
- Constitutional rights violations and other police misconduct
The IRS determined that the entire settlement amount was taxable income, but Zajac argued that some or all of it should be excluded under §104(a)(2) as compensation for personal physical injuries.
Section 104(a)(2):
A limited exclusion for “the amount of any damages (other than punitive damages) received… on account of personal physical injuries or physical sickness” is provided in Section 104(a)(2). Importantly, emotional distress alone does not qualify as physical injury or sickness, but damages for emotional distress attributable to physical injuries can be excluded.
When analyzing settlement payments, the critical question is “in lieu of what was the settlement amount paid?” The court must determine the payor’s dominant reason for making the payment, looking at the facts and circumstances leading to the settlement and the allegations in the injured party’s complaint.
Court Decided That Some of the Settlement Was for Personal Injury:
The Tax Court acknowledged that the settlement agreement itself provided no clarity about the nature of the payment, so they had to determine the Town of Bolton’s intent.
The court found Zajac’s evidence persuasive regarding his claims of physical injuries resulting from the arrest and incarceration. They specifically noted:
- The claim letter described cuts, bruises, and exacerbation of preexisting conditions
- The experience of pain itself constitutes physical injury for purposes of Section 104(a)(2)
- The emotional distress Zajac claimed was associated with these physical injuries, making it potentially excludable
However, the court also recognized that Zajac’s claims included other significant allegations of constitutional rights violations and police misconduct unrelated to physical injury.
Using what it called its “best judgment,” the court concluded that the Town of Bolton made the payment partially to settle potential liability for physical pain and injuries, and partially for other claims. The court divided the $35,001 settlement precisely in half (plus $1), allocating $17,500 as excludable under Section 104(a)(2) and $17,501 as taxable income.
Tax Practitioner Planning:
- Documentation matters: The vague settlement agreement forced the court to look at other evidence to determine the payor’s intent. Clearer settlement agreements specifying the allocation of payments could have prevented litigation.
- Physical pain qualifies: The court reaffirmed that experiencing physical pain constitutes physical injury under Section 104(a)(2).
- Emotional distress can be excludable: While emotional distress alone doesn’t qualify for exclusion, damages for emotional distress attributable to physical injuries are excludable.
- Mixed settlements require allocation: When settlement payments address both physical injuries and other claims, the court will determine which portion is attributable to each unless the agreement specifies amounts for each claim.
- Payor’s intent is paramount: This court’s analysis focuses on the intent of the payor, not the payee’s understanding or characterization of the payment.
This case serves as an important reminder to clearly document the nature and purpose of settlement payments in agreements. When representing clients in personal injury settlements, tax professionals should advise on the importance of specifically allocating settlement amounts to avoid future tax disputes.