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Where damages are received pursuant to a settlement agreement, the nature of the claim that was the actual basis for settlement controls whether such damages are excludable under 26 U.S.C.S. § 104(a)(2). The determination of the nature of the claim is factual. Where there is a settlement agreement, that determination is usually made by reference to it. If the settlement agreement lacks express language stating what the amount paid pursuant to that agreement was to settle, the intent of the payor is critical to that determination. Although the belief of the payee is relevant to that inquiry, the character of the settlement payment hinges ultimately on the dominant reason of the payor in making the payment. Whether the settlement payment is excludable from gross income under 26 U.S.C.S. § 104(a)(2) depends on the nature and character of the claim asserted, and not upon the validity of that claim.
Eugene Amos, Jr. filed a tax return ("return") for his taxable year 1997. In that return, Amos excluded from his gross income $200,000 that he received from Mr. Rodman under a settlement agreement. In the notice that the Commissioner of Internal Revenue ("Commissioner") issued to Amos with respect to 1997, the Commissioner determined that Amos is not entitled to exclude from his gross income the settlement amount at issue.
Was the entire $200,000 settlement amount that Amos received in 1997 in settlement of a claim excludable under section 104(a)(2)?
The Court noted that the Amos bore the burden of proving that the determination in the notice to include the settlement amount at issue in the gross income was erroneous. 26 U.S.C.S. § 104(a)(2) on which the taxpayer relief provided that gross income did not include the amount of any damages (other than punitive damages) received on account of personal physical injuries or physical sickness. Amos had to demonstrate that the underlying cause of action that gave rise to the recovery was based upon tort or tort type rights, and that the damages were received on account of personal injuries or sickness. It was Amos’ position that the entire settlement amount was excludable. The Court found that a portion of the settlement amount was paid in return for Amos’ agreement not to disclose the existence of the settlement agreement, among other things. The court held that $120,000 was excludable, but $80,000 was not.