Business owners and independent contractors sometimes receive legal settlements to resolve disputes. While most settlement proceeds must be reported as taxable income, payments for physical injuries or physical sickness can be excluded under specific sections of the tax code. This exemption can significantly impact the amount of tax due.
The tax consequences focus on the legal documents that are filed and those that are executed. The terms of the settlement agreement are particularly important. But what happens when a settlement agreement lacks clear language about the nature of the payment? How does one determine which portion, if any, is excludable from gross income? And what evidence must taxpayers have to support their position?
The recent case of Zajac v. Commissioner, T.C. Memo. 2025-33, provides an opportunity to consider these questions. This is a case that involves a settlement agreement that only contains general release language without specifying which claims are being compensated.
Facts & Procedural History
The taxpayer was arrested in on domestic assault and battery charges in 2004 after his wife alleged he had physically attacked her. He was incarcerated over the weekend, and despite requesting medical attention, he did not receive any. When the taxpayer was arraigned on the criminal charges, his wife declined to testify against him and the charges were dropped.
In September 2005, the taxpayer sent a claim letter to the Town of Bolton seeking $100,000 in damages resulting from the arrest and incarceration. He claimed physical and emotional injuries as well as violations of his constitutional rights. In April 2007, the parties settled the claim for $35,001, with the taxpayer releasing all claims resulting from “the accident, casualty or event which occurred on or about May 1, 2004.”
EThe taxpayer did not include the $35,001 settlement in his gross income for 2007 on his income tax return. The IRS conducted an audit and determined deficiencies and penalties for tax years 2007-2009. After receiving a notice of deficiency from the IRS, the taxpayer filed a petition with the U.S. Tax Court to dispute the tax liability.
The Broad Scope of of Section 61
Section 61(a) of the tax code defines gross income broadly as “all income from whatever source derived.” This sweeping definition reflects Congress’s intent to exercise its full taxing power by capturing any accession to wealth, unless specifically excluded by statute.
The Supreme Court emphasized this broad scope in Commissioner v. Glenshaw Glass Co., noting that Congress intended to tax all gains except those specifically exempted. This means that settlement proceeds, like other forms of income, are presumptively included in gross income unless a taxpayer can establish that a specific statutory exclusion applies.
Given this framework of a broad rule with narrow exclusions, taxpayers bear the burden of proving that settlement proceeds qualify for exclusion under one of the narrow exceptions to the general rule of taxability. Courts consistently interpret these exclusions narrowly, requiring taxpayers to present clear evidence supporting their position.
The Section 104(a)(2) Exclusion for Physical Injuries
Section 104(a)(2) provides a specific exclusion from gross income for “the amount of any damages (other than punitive 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.”
This exclusion contains several key elements:
- The payment must constitute “damages” (not, for example, wages or benefits)
- The damages must be received through a lawsuit or settlement
- The damages must be “on account of” personal injuries or sickness
- The personal injuries or sickness must be “physical” in nature
The statute specifically addresses emotional distress, stating that it is not treated as a physical injury or physical sickness. This distinction became especially important after the 1996 amendments to Section 104(a)(2), which added the word “physical” to clarify that damages for emotional distress alone are not excludable.
However, an important exception exists: damages for emotional distress can be excludable if they are “attributable to a physical injury or physical sickness” according to Treasury Regulation §1.104-1(c)(1). This means that emotional distress damages stemming from a physical injury may qualify for exclusion.
What Constitutes “Physical Injury” Under The Tax Code?
The tax code does not explicitly define “physical injury,” leaving courts to interpret this term on a case-by-case basis. The courts havve developed some guidelines through their court decisions.
In Amos v. Commissioner, for example, the court found that experiencing pain from a physical impact (in that case, a kick to the groin) constituted a physical injury for purposes of Section 104(a)(2), even without serious signs of trauma. Similarly, in Domeny v. Commissioner, the court determined that pain flare-ups from pre-existing conditions of multiple sclerosis caused by the settlement payor’s conduct qualified as physical injuries.
These cases establish that pain itself, even without visible trauma, can constitute a physical injury under Section 104(a)(2). This interpretation is particularly relevant for situations involving the aggravation of pre-existing conditions, where the injury might manifest primarily as increased pain rather than new, visible physical damage.
For taxpayers dealing with IRS audits related to settlement proceeds, understanding this broader interpretation of “physical injury” can be crucial to properly defending their tax positions.
How Do Courts Determine the Purpose of Settlement Payments?
This brings us to the issue in this case. When a taxpayer receives damages through a settlement agreement, one has to determine what the payment was intended to compensate in order to figure out the tax treatment. As the tax court stated in Bagley v. Commissioner, “the critical question is, in lieu of what was the settlement amount paid.”
The Fifth Circuit elaborated on this principle in Green v. Commissioner, holding that “the character of the payment hinges on the payor’s dominant reason for making the payment.” This focus on the payor’s intent, rather than the recipient’s characterization or use of the funds, is central to the analysis.
Courts typically examine several factors to determine the payor’s intent:
- The language of the settlement agreement
- The nature of the claims asserted in the original complaint or claim letter
- The context and content of settlement negotiations
- Any other evidence that might reveal why the payor made the payment
When a settlement agreement contains specific allocation language, courts generally respect that allocation unless there is evidence that it does not reflect the economic reality of the settlement. However, when the agreement is broad and inclusive, such as a general release of claims without specific allocations, courts look to extrinsic evidence to determine the nature of the payment.
Allocating Settlement Proceeds Between Excludable and Non-Excludable Portions
When a settlement compensates for multiple claims, some related to physical injuries and others not, courts have the authority to determine which portion is attributable to each type of claim. There are several court cases that say this. For example, in Henderson v. Commissioner, the Tax Court established that it may allocate a settlement payment between excludable physical injury damages and non-excludable damages for other claims.
This allocation process involves a fact-intensive inquiry into what motivated the payor to make the settlement payment. The court must determine, based on the available evidence, how much of the payment was intended to compensate for physical injuries or physical sickness.
For taxpayers facing IRS adjustments to income related to settlement proceeds, this judicial authority to allocate proceeds is significant. It means that even without an explicit allocation in the settlement agreement, a taxpayer may be able to exclude a portion of the proceeds if they can demonstrate the payor’s intent to compensate for physical injuries.
The Example from this Case
In the Zajac case, the tax court considered a settlement agreement with broad release language that did not specify which claims were being compensated. The agreement merely stated that the $35,001 payment was made on account of “the accident, casualty or event which occurred on or about May 1, 2004[,] at or near Bolton, MA.”
The IRS argued that none of the settlement should be excludable under Section 104(a)(2). They pointed to the taxpayer’s description of the settlement in a later lawsuit against his former wife, which mentioned various claims but did not specifically reference physical injury or sickness.
The tax court rejected the IRS’s argument. It noted that the test focuses on the intent of the payor (the Town of Bolton), not the payee’s later characterization. The court then examined the information available to the town at the time it made the settlement decision.
The taxpayer’s claim letter to the Town of Bolton asserted multiple physical injuries:
- Cuts and bruises from excessive force during his arrest
- Exacerbation of pre-existing lower back and knee conditions
- Injuries to his wrists, knees, and ankles during the arrest
The letter also claimed emotional distress associated with these physical injuries, which would be excludable under Treasury Regulation §1.104-1(c)(1).
However, the claim letter also alleged various constitutional rights violations and other claims unrelated to physical injuries. The court concluded that the Town of Bolton likely made the payment partly to settle potential liability for the taxpayers physical pain and injuries, and partly for the other claims.
Using its judgment, the court determined that $17,500 of the $35,001 settlement was attributable to physical injury claims and therefore excludable from gross income under Section 104(a)(2). The remaining $17,501 was deemed attributable to other claims and thus includible in gross income.
The Challenges of Vague Settlement Agreements
This case provides an example of the complications that arise when settlement agreements lack specificity about the nature of claims being compensated. When agreements contain only general release language, both taxpayers and the IRS face uncertainty about the proper tax treatment of the proceeds.
This uncertainty can lead to disputes years after the settlement, as taxpayers may exclude amounts that the IRS later challenges, or include amounts that could have been properly excluded. Either scenario can result in unnecessary Tax Litigation and potential penalties.
To avoid these issues, parties to settlement agreements should:
- Include explicit language about the nature of the claims being settled
- Allocate specific dollar amounts to each type of claim
- Ensure the allocation reflects the economic reality of the settlement
- Document the payor’s understanding of the purpose of the payment
For taxpayers who have already received settlements with vague agreements, maintaining documentation of the underlying claims and the payor’s intent becomes especially important if the IRS questions the tax treatment of the proceeds.
This is particularly important given that the IRS is likely to impose accuracy-related penalties for failing to report settlement proceeds.
The Takeaway
This case affirms that courts can allocate settlement payments between excludable and non-excludable portions based on evidence of the payor’s intent, even when settlement agreements lack specificity. The case also reinforces that physical pain, including the exacerbation of pre-existing conditions, can qualify as a physical injury under Section 104(a)(2). To minimize tax disputes, settlement agreements should explicitly allocate proceeds among different types of claims and clearly document the payor’s intent. These practices help ensure proper tax treatment and reduce the likelihood of conflicts with the IRS over settlement proceeds. For taxpayers who have already received settlements with vague agreements, maintaining documentation of the underlying claims and injuries becomes essential if the IRS challenges their tax treatment.