Settlement Proceeds from Class Action Breach of Contract Suit Excludible under §104(a)(3)

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By Theodore D. Peyser, Esq.Roberts & Holland LLP, Washington, DC and New York, NY

In Watts v. Comr., T.C. Memo 2009-103, the taxpayer sought to exclude from gross income $52,896 received in 2002 as a result of a settlement of a class action suit on the ground that this amount represented damages for personal physical injuries she suffered in an automobile accident, excludible under §104(a)(2). While the Tax Court rejected Taxpayer's (a)(2) argument, it held in her favor based on the exclusion for amounts received through accident insurance found in §104(a)(3).

Factual Background

In 1992, Taxpayer was injured in an automobile accident, which was the fault of an uninsured motorist. As a result of her injuries, she was unable to work for over a year. Taxpayer and her husband had two State Farm automobile accident insurance policies, each of which included $50,000 of coverage for uninsured and underinsured motorists (UM/UIM). State Farm took the position that Taxpayer was entitled to recover under the UM/UIM coverage on only one of the two policies, resulting in an effective limit of $50,000 based on anti-stacking provisions of the policies. Taking into account this anti-stacking defense, Taxpayer settled her claim against State Farm for a payment in 1996 of $32,973.

After Taxpayer agreed to settle with State Farm, the Arizona Supreme Court held anti-stacking provisions in certain State Farm policies similar to Taxpayers's to be ineffective. Taxpayer then became a member of the plaintiff class in a class action lawsuit against State Farm for breach of contract and other wrongful conduct. Eventually, the suit was settled and pursuant to the settlement Taxpayer received in 2002 the sum of $52,896.

The §104(a)(2) Exclusion for Damages for Personal Physical Injuries

Taxpayer argued that the payment of $52,896 received in 2002 was excludible from gross income under §104(a)(2) as damages received on account of personal physical injuries she suffered in the automobile accident. The IRS position was that the payment was not to settle a tort claim or to pay Taxpayer on account of personal physical injuries but rather to redress contract claims. The Tax Court accepted the IRS position, concluding that the payment was received in settlement of the contract dispute concerning the terms of the policies regarding injury caused by an uninsured motorist. A crucial fact was that the class action lawsuit and settlement were not against the motorist who caused the injury or that motorist's insurer; there was no suit based on tort or tort-type rights.

The §104(a)(3) Exclusion for Amounts Received Through Accident or Health Insurance

The Tax Court went on to consider the applicability of the §104(a)(3) exclusion for amounts received through accident insurance. The first point was that the uninsured motorist coverage in Taxpayer's policies was “accident or health insurance” within the meaning of this Code section. The second was whether the amount received in 2002 was “through” accident or health insurance. Under the settlement of the class action lawsuit, to be eligible for the payment, Taxpayer was required to have been insured under multiple State Farm policies with UM/UIM coverage, injured through the fault of an uninsured or underinsured motorist, and denied payment under one of these policies while receiving payment under another. The Tax Court concluded that these requirements established that the payment to Taxpayer was “through” accident insurance or under such a policy. But for her status as an insured under the second policy, Taxpayer would not have received the settlement payment.

The final issue was whether the payment in 2002 was received “for” personal injuries or sickness. To qualify for payment, Taxpayer had to have sustained personal injury for which she had not been fully compensated. This indicated to the Tax Court that she received her share of the settlement funds in significant part because she had uncompensated personal injuries. On the other hand, the class action lawsuit involved claims in addition to those premised on personal injury (breach of contract, breach of covenant of good faith and fair dealing, fraud, violation of the Arizona Consumer Fraud Act, breach of fiduciary duty, and racketeering) and sought compensatory damages, treble damages, punitive damages, and prejudgment interest, and it could be argued that plaintiff failed to prove that any portion of the payment in 2002 was made for personal injury.

The Tax Court was convinced that the 2002 payment to Taxpayer up to the $50,000 policy limit on UM/UIM coverage was for personal injuries based on the requirement in the settlement agreement that she was not fully compensated for her injuries and the evidence that she had extensive injuries, that she was out of work for a year, and anticipated medical expenses in future years when she settled in 1996. The Tax Court concluded that the remaining $2,896 received in 2002 was attributable to something other than personal injuries and thus includible in gross income.

The Watts opinion illustrates the need for attention to the detailed requirements of the five exclusions included in §104 and the desirability in some cases of asserting alternative arguments for an exclusion.

For more information, in the Tax Management Portfolios, see Wood, 522 T.M., Tax Aspects of Settlements and Judgments, and in Tax Practice Series, see ¶1340, Payments Pursuant to Judgments and Settlements.