SC Administrative Law Court Decisions

This matter is before the Administrative Law Judge Division pursuant to the Petitioners' (the Taxpayers, or Taxpayer Husband, individually) request for a contested case hearing under S.C. Code Ann. § 12-60-460 (2000). A hearing was held at the offices of the Administrative Law Judge Division (ALJD) on August 15, 2001.

At that hearing, the following four issues were raised:

1. Did the South Carolina Department of Revenue (Department) properly include money received in the settlement of a lawsuit in the Taxpayers' gross income?

2. Did the Department properly include the entire settlement amount in the Taxpayers' gross income and properly provide the Taxpayers a miscellaneous itemized deduction for the attorney's fees incurred in the civil action?

3. Is the Department equitably estopped from claiming the settlement proceeds are taxable?

4. Are the Taxpayers entitled to prospective treatment with regard to the 1996 amendments to IRC Section 104(a)(2)?

Having observed the witnesses and exhibits presented at the hearing and closely passed upon their credibility, taking into account the burden of persuasion by the parties, I make the following Findings of Fact by a preponderance of the evidence:

1. Notice of the time, date, place, and subject matter of the hearing was given to the Taxpayers and the Department.

2. The Taxpayers are husband and wife. The Taxpayer Husband was employed by the South Carolina Department of Education (SCDOE). On March 2, 1992, the Taxpayer Husband filed a civil action in the United States District Court against the State Superintendent of Education in the Superintendent's individual and official capacities. The Taxpayer Husband alleged in his Complaint that he was never given any meaningful opportunity for proper employment solely because of his political affiliation. The Taxpayer Husband also alleged that the Superintendent's political discrimination and retaliation forced him to retire against his will. The Taxpayer Husband further alleged the Superintendent's political discrimination placed him "in apprehension that continued stress would weaken his heart condition." (emphasis added).

The Taxpayer Husband alleged in the Complaint that as a proximate result of the Superintendent's actions, he suffered loss of earnings, loss of earning capacity, loss of future retirement benefits, loss of his excellent reputation as a state employee, loss of self-esteem, mental anguish, and a lesser quality of life. However, he did not allege in the Complaint that the Superintendent's actions actually caused him any personal physical injury or physical sickness.

3. On November 30, 1997, the parties entered into a "Settlement Agreement and Release in Full." This agreement provided that the South Carolina Insurance Reserve Fund would pay the Taxpayer Husband $326,600.00 "for the personal injury damages alleged in the Civil Action and in full and complete settlement of all claims that [the Taxpayer Husband] has or in the future may be entitled to have against [the Superintendent] and/or the South Carolina Department of Education." The Taxpayer Husband released the State of South Carolina and all of its agents from, among other things, any and all claims alleged in the civil action or purporting to arise under Title VII of the Civil Rights Act of 1964. However, the settlement agreement made no mention of a specific personal physical injury or physical sickness, and further stated that it constituted the entire agreement between the parties.

4. The Taxpayers timely filed their 1997 South Carolina income tax return, but did not include the $326,600.00 received in the aforementioned settlement in gross income. Afterwards, the Department's Field Services Division subsequently audited the Taxpayers' 1997 tax return and found that the $326,600.00 was not received on account of a personal physical injury or physical sickness. Therefore, the Department determined that the Taxpayers should have included this amount in gross income. The Department adjusted the Taxpayers' return to include the $326,600.00 in gross income and provided a miscellaneous itemized deduction for attorney's fees and expenses. A proposed assessment was issued for additional tax totaling $16,228.00. The assessment also charged interest and a substantial understatement of tax penalty.

Based upon the above Findings of Fact, I conclude the following as a matter of law:

1. The ALJD has jurisdiction to hear this matter pursuant to S.C. Code Ann. § 12-60-460 (2000).

2. Generally, the burden of proof is on the party asserting the affirmative in an adjudicatory administrative proceeding. 2 Am. Jur. 2d Administrative Law § 360 (1994). In the present case, the Taxpayers are seeking to prove that the Department's assessment of their income tax was incorrect, as none of the amount received under the settlement agreement was taxable. When the Department declined to change its assessment, the Taxpayers requested and obtained this contested case hearing in order to show that the Department's assessment was incorrect. Therefore, the Taxpayers assert the affirmative on this issue and must carry the burden of proving that the Department's assessment is incorrect. Id.; cf. Cloyd v. Mabry, 295 S.C. 86, 88-89, 367 S.E.2d 171, 173 (Ct. App. 1988) (a taxpayer contesting an assessment has the burden of showing that the valuation of the taxing authority is incorrect). ⁽¹⁾ In addition, the Taxpayers bear the burden of proving that the $326,600.00 settlement falls within an exclusion. See Hollingsworth on Wheels, Inc. v. Greenville County Treasurer, 276 S.C. 314, 317, 278 S.E.2d 340, 342 (1981) ("The language of a tax exemption statute must be given its plain, ordinary meaning and must be strictly construed against the claimed exemption.").

3. A basic premise upon which our federal and state income tax systems are structured is that all income is taxable unless an exclusion is allowed by law. This premise is codified at IRC Section 61 and Treas. Reg. Section 1.61-1, which have been adopted by South Carolina. ⁽²⁾ IRC Section 61 reads: "[e]xcept as otherwise provided in this subtitle, gross income means all income from whatever source derived." Reinforcing and clarifying this principle, Treas. Reg. Section 1.61-1 reads, in part: "[g]ross income means all income from whatever source derived, unless excluded by law."

4. IRC Section 104(a)(2) provides that "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" may be excluded from gross income. Section 104(a)(2) is effective with respect to amounts received after August 20, 1996. In keeping with federal conformity, South Carolina adopted this provision. ⁽³⁾ Thus, South Carolina's treatment of such income is the same as that indicated above. See S.C. Code Ann. § 12-6-50 (2000). Furthermore, Section 104(a)(2) represents an amendment to the previous statute by adding the word "physical." Thus, after August 20, 1996, injuries not only must be "personal" but also must be "physical."

5. The Taxpayer Husband signed the settlement agreement on November 30, 1997, and the income in question was received in 1997. Therefore, the provision adding the word "physical" is applicable to the Taxpayers. Thus, the amount paid to the Taxpayer Husband by the South Carolina Insurance Reserve Fund must have been "on account of personal physical injuries or physical sickness" in order for it to be excludable from gross income.

Though there has been no reported case law interpreting the term "personal physical injury," the Congressional Committee Reports on this amendment are very instructive as to the intent of the language. The Committee Reports indicate that emotional distress is not considered a physical injury or physical sickness. Therefore, the exclusion from gross income does not apply to any damages received, other than certain specified medical expenses, based on a claim of employment discrimination or injury to reputation accompanied by a claim for emotional distress. See House Committee Reports on P.L. 104-188 (Small Business Job Protection Act of 1996). Furthermore, in a footnote to the Committee Reports, the term emotional distress is defined to include physical symptoms (e.g., insomnia, headaches, stomach disorders) which may result from such emotional distress.

Consistent with the above Committee Reports, the IRS issued two policy documents on this topic subsequent to the change in the law. These documents are Revenue Ruling #96-65, 1996-2 C.B. 6, and Internal Revenue Service, Market Segment Specialization Program Guideline, Lawsuits Awards and Settlements, 2000 WL 33171829. Revenue Ruling #96-65 specifically addresses the issue of whether damages received in an employment discrimination suit are excludable from income. The ruling explains the prior law and the present law and concludes that such is taxable under current law except to the extent that such damages are paid for medical care attributable to emotional distress.

The Market Segment Specialization Program Guideline clarifies Revenue Ruling #96-65 by stating that a taxpayer can only exclude actual out-of-pocket medical costs. Further, the excludability of the out-of-pocket medical costs also depends upon whether a taxpayer has previously deducted those medical expenses on his tax return. The guideline provides a discussion of the taxability of employment related lawsuit awards (e.g., wrongful discharge) and employment related discrimination suit awards. In both instances, it concludes that a taxpayer can only exclude damages not exceeding medical costs paid to treat any emotional distress.

6. The Taxpayers argue that the $326,600.00 settlement falls within the exclusion provided by IRC Section 104(a)(2) because it was received on account of personal physical injury or physical sickness. However, the Taxpayer Husband's civil action is based on political harassment, discrimination, and retaliation in an employment setting. The Taxpayer Husband never alleged in the civil action that the Superintendent's actions actually caused him any personal physical injury or physical sickness. To the contrary, it is only alleged that the Superintendent's discrimination "placed the plaintiff [Taxpayer Husband] in apprehension that continued stress would weaken his heart condition." (emphasis added). Apprehension of an injury is not personal physical injury or physical sickness for purposes of Section 104(a)(2). Furthermore, when listing the proximate results of the Superintendent's actions, the civil action does not allege that the Taxpayer Husband suffered any personal physical injury or physical sickness. It is only alleged that the Taxpayer Husband "suffered a loss of earnings, has suffered a loss of earning capacity and future retirement benefits; and has suffered a loss of his heretofore excellent reputation as a state employee. Plaintiff has also suffered mental anguish, loss of self-esteem, and a lesser quality of life."

Pursuant to the settlement agreement, the South Carolina Insurance Reserve Fund agreed to pay the Taxpayer Husband $326,600.00 "for the personal injury damages alleged in the Civil Action and in full and complete settlement of all claims that [the Taxpayer Husband] has or in the future may be entitled to have against [the Superintendent] and/or the South Carolina Department of Education." The settlement agreement specifically described the allegations contained in the civil action as follows:

WHEREAS, [the Taxpayer Husband] alleges in the Civil Action that he was discriminated against on the basis of his political affiliation and his political activities in violation of the First Amendment to the United States Constitution and 42 U.S.C. § 1983[.]

Furthermore, as stated above, the Taxpayer Husband never alleged in the civil action that he suffered any physical injuries nor were physical injuries ever mentioned in the settlement agreement.

In support of their argument, the Taxpayers introduced into evidence Taxpayer Husband's answer to Defendant's first set of interrogatories, the deposition of Taxpayer Husband in the underlying civil action, and various medical articles. However, none of these documents support the Taxpayers' argument that the settlement was received on account of personal physical injury or physical sickness. First, Interrogatory 12 asked the Taxpayer Husband to explain how "his working conditions were made totally intolerable" by the Superintendent's actions. In answering this interrogatory, the Taxpayer Husband stated that his "stress level increased and he feared his heart condition may recur." Second, in the Taxpayer Husband's deposition, he was asked several questions regarding his medical condition. The Taxpayer Husband's answers to these questions indicate that he may have suffered from stress, but did not sustain any physical injury or physical sickness. In particular, the Taxpayer Husband testified that a stress test conducted by his doctor did not detect any physical problems. Finally, the medical articles introduced by the Taxpayers do not indicate that the Taxpayer Husband sustained any physical injury or physical sickness.

The evidence simply does not support the Taxpayers' argument that the settlement proceeds were received on account of personal physical injury or physical sickness. Therefore, I find that Taxpayer Husband did not suffer a specific personal or physical injury for which he entered into the settlement but rather that his civil action was based on political harassment, discrimination, and retaliation in an employment setting. As such, only out-of-pocket medical expenses are excludable from gross income. The Taxpayers have not presented any evidence regarding the existence of out-of-pocket medical expenses; thus, the $326,600.00 received by the Taxpayers is taxable income.

7. The Department adjusted the Taxpayers' 1997 income tax return to include the entire settlement amount in gross income. The Department then allowed the Taxpayers a miscellaneous itemized deduction for the attorney's fees incurred in the civil action. ⁽⁴⁾ The Taxpayers argue that the entire portion of the settlement proceeds used to pay these attorney's fees should be excluded from gross income. This argument is without merit.

The United States Supreme Court has held that the assignment to another of income not yet received does not relieve the assignor of tax liability on that income. Helvering v. Horst, 311 U.S. 112 (1940); Lucas v. Earl, 281 U.S. 111 (1930). A majority of courts have applied the anticipatory assignment doctrine to hold that when a taxpayer's attorney is compensated directly from the proceeds of a settlement or judgment, the taxpayer enjoys an economic gain, which must be included in the taxpayer's gross income. The Court of Appeals for the First, Third, Fourth, Seventh, Ninth, and Federal Circuits, and the United States Tax Court have all held that the portion of a settlement or judgment payable to the taxpayer's attorney is includable in the taxpayer's gross income, regardless of whether the taxpayer took actual possession of the money. See Kenseth v. Commissioner, 114 T.C. 399 (2000), aff'd, 259 F.3d 881 (7^th Cir. 2001); Young v. Commissioner, 240 F.3d 369 (4^th Cir. 2001); Coady v. Commissioner, 213 F.3d 1187 (9th Cir. 2000); Alexander v. I.R.S., 72 F.3d 938 (1^st Cir. 1995); Baylin v. United States, 43 F.3d 1451 (Fed. Cir. 1995); O'Brien v. Commissioner, 38 T.C. 707 (1962), aff'd, 319 F.2d 532 (3^rd Cir. 1963).

In this case, the Taxpayers received the full economic benefit of the settlement proceeds used to pay the attorney's fees in the form of payment for the services required to obtain the settlement. Therefore, though the Taxpayers properly entered into an arrangement in which their attorney was compensated directly from the settlement proceeds, that portion of the settlement proceeds is still considered by the courts to be income. Accordingly, the portion of the settlement proceeds payable to the Taxpayer Husband's attorney is not excludable from the Taxpayers' gross income.

8. The Taxpayers argue that the Department is equitably estopped from claiming the settlement proceeds are taxable. The essential elements of equitable estoppel are: (1) lack, on the part of the one claiming estoppel, of the knowledge and means of knowledge of the truth as to the facts and circumstances upon which his claim of estoppel is predicated; (2) conduct, representations, or silence of the party estopped, amounting to misrepresentation or concealment of facts; (3) reliance upon such conduct, representations, or silence; and (4) resulting action, to its detriment, by the party claiming the estoppel. Berkeley Elec. Co-op., Inc. v. Town of Mount Pleasant, 308 S.C. 205, 210, 417 S.E.2d 579, 582 (1992). Moreover, the South Carolina Supreme Court has recognized that the doctrine of equitable estoppel "will not be applied to deprive the government of the due exercise of its police power, or to effect public revenues or property rights, or to frustrate the purposes of its laws or thwart its public policy." Heyward v. South Carolina Tax Commission, 240 S.C. 347, 351, 126 S.E.2d 15, 17 (1962); See also Texaco, Inc. v. Wasson, 269 S.C. 255, 237 S.E.2d 75 (1977).

In this case the elements of equitable estoppel do not exist. The following provisions in the settlement agreement addressed the potential taxability of the settlement proceeds:

a. Paragraph 3 provides that the SCDOE, the Superintendent, and their counsel made no representations as to any position a taxing authority might take regarding the settlement payment. In addition, the Taxpayer Husband specifically acknowledges that he relied or will rely solely on the advice of others in this regard;

b. Paragraph 7 provides that the settlement agreement constitutes the entire agreement between the parties; and

c. Paragraph 8 provides that neither the Superintendent, the SCDOE, nor any of their agents, representatives, or attorneys made any representations to the Taxpayer Husband concerning the terms or effects of the settlement agreement.

Therefore, the settlement agreement clearly establishes that the Taxpayer Husband was fully informed of the potential taxability of the settlement proceeds and that the Superintendent made no representations regarding the taxability of the proceeds.

9. The Taxpayers argue that they are entitled to prospective treatment with respect to the 1996 amendments to IRC Section 104(a)(2). The United States Congress amended IRC Section 104(a)(2) in 1996. The amendments applied to amounts received after the date of enactment of the act, which was August 20, 1996. Pursuant to Act No. 155, 1997 S.C. Acts, Part II, Section 10, the State of South Carolina adopted the provisions of the Internal Revenue Code as amended through December 31, 1996, including the effective date provisions contained therein.

The Taxpayer Husband originally filed his civil action on March 2, 1992. While his case was pending, Section 104(a)(2) was amended. The effective date of the amendments was August 20, 1996. However, the amendment to Section 104(a)(2) includes language providing that the amendments did not apply to any amount received under a written binding agreement, court decree, or mediation award in effect on (or issued on or before) September 13, 1995. The Taxpayer Husband settled his case on November 30, 1997, over one year following the amendments to IRC Section 104(a)(2). Accordingly, prospective treatment is not appropriate in this case.

10. The Department has assessed interest at the prevailing federal rate. S.C. Code Ann. § 12-54-25(A) (2000) provides that interest is due on unpaid taxes. The interest rate is established by S.C. Code Ann. § 12-54-25(D) (2000) and is not discretionary. Unlike a penalty, there is no South Carolina statute which grants general authority to waive interest. ⁽⁵⁾ Although there is a statute which allows interest to be compromised, that provision anticipates a settlement or quid pro quo. This is found in S.C. Code Ann. Section 12-4-320(3) (2000) which reads as follows:

The department may:

* * *

(3) compromise any tax, interest, or penalty imposed by this title or other law assigned to it . . . .

The ALJD recognized this section as the authority of the Department to settle cases in S.C. Department of Revenue v. Bonita Williams d/b/a 6300 Club, 98-ALJ-17-0191-CC. Thus, compromising the interest would not be appropriate in this case because there was no settlement between the parties in this contested case. Further, Section 12-4-320(3) also refers to compromising penalties. If the Legislature had intended the word "compromise" to mean the same as "waiver" of a penalty, then S.C. Code Ann. Section 12-54-160 (2000) regarding waiver of penalties would be superfluous. Interest is not a penalty. It is a charge for the time value of money. As such, there is no statutory authority to waive interest. Accordingly, I find that interest must be assessed until the tax is paid.

11. The Department assessed a substantial understatement of tax penalty pursuant to S.C. Code Ann. § 12-54-155 (2000). The penalty is an amount equal to twenty-five percent of the amount of any underpayment attributable to the understatement of tax. S.C. Code Ann. § 12-54-160 (2000) provides that the Department may waive, dismiss, or reduce penalties. The Department has issued S.C. Revenue Procedure #98-3 to provide guidance regarding the waiver of penalties. The Revenue Procedure provides, inter alia, that penalties may be waived in situations where difficult and complex issues exist or where there has been a recent change in the law that the Taxpayers could not reasonably be expected to be aware of. I find that the issues presented in this case are complex issues. Accordingly, I hereby waive the understatement of tax penalty.

Based upon the foregoing Findings of Fact and Conclusions of Law:

IT IS HEREBY ORDERED that the settlement proceeds received by the Taxpayers totaling $326,600.00 are subject to state income tax. The Department may assess additional state income tax in the amount of $16,228.00, with interest calculated commensurate with payment.

IT IS FURTHER ORDERED that the this tax is due and payable thirty days from the date of this Order with such interest to be calculated as of the date of this Order, in keeping with S.C. Code Ann. § 12-54-25(A), to allow the parties additional time to calculate the final amount owed.

AND IT IS SO ORDERED.

Ralph King Anderson, III

Administrative Law Judge

December 13, 2001

Columbia, South Carolina

1. Other jurisdictions have reached the same conclusion. See, e.g., In re Broce Const. Co. Inc., 9 P.3d 1281, 1290 (Kan. Ct. App. 2000) ("[O]ur Supreme Court has long held that 'the tax found by the tax commission to be due is presumed to be valid [and] the taxpayer has the burden of showing its invalidity.' ") (Citations omitted).

2. See S.C. Code Ann. § 12-6-50 (2000) which lists all Internal Revenue Code sections which have not been adopted by South Carolina. All other Internal Revenue Code sections have been adopted pursuant to S.C. Code Ann. § 12-6-40 (2000).

3. See S.C. Code Ann. § 12-6-40 (2000) indicating that South Carolina has adopted the Internal Revenue Code of 1986 as amended through December 31, 1998, and includes the effective date provisions therein.

4. IRC Section 212(1) grants a deduction for all the ordinary and necessary expenses paid or incurred for the production or collection of income.

5. S.C. Code Ann. § 12-54-25(A) (2000) allows the Department to waive only up to thirty days' interest for purposes of administrative convenience.