ORDERS:
FINAL ORDER AND DECISION
I. Introduction
Anonymous Taxpayers are a husband and wife who filed a joint South Carolina income tax return for tax year 1997. The
South Carolina Department of Revenue (DOR) asserts that funds received by the wife (taxpayer) in 1997 were taxable.
The taxpayer disagrees and argues the funds are excluded from taxation by statute. The disagreement and the taxpayer's
request for a contested case hearing has brought the matter to the Administrative Law Judge Division. See S.C. Code Ann.
§ 12-60-460 (Supp. 2000).
II. Issues
1. Is DOR equitably estopped from claiming the settlement funds received by the taxpayer in 1997 are taxable?
2. Is the 1996 amendment to IRC § 104(a)(2) applicable to the taxpayer's 1997 tax year?
3. Are the funds received by the taxpayer in 1997 excluded from taxation due to the funds being received on account of
personal physical injury or physical sickness?
4.. Is the portion of the taxpayer's funds that was paid to the taxpayer's attorney included in the taxpayer's 1997 gross
income?
5. Is the taxpayer liable for a penalty for filing a return that contained a substantial understatement of tax?
III. Analysis
A. Equitable Estoppel
1. Positions of Parties
The taxpayer argues that DOR is equitably estopped from taxing her settlement proceeds. DOR counters that equitable
estoppel does not apply in the collection of taxes and even if it did, no grounds for estoppel have been established.
2. Findings of Fact
I find by a preponderance of the evidence the following facts:
Taxpayer received settlement proceeds as the result of ending a claim against the a state agency and the director of that
agency. At the time of the settlement, taxpayer believed she had previously received assurances from agents of the state
that the proceeds payable to her would be non-taxable. However, the settlement agreement signed by the taxpayer states
that no state official had given any advice on the taxability of the settlement proceeds. Further, no official from DOR gave
any advice on the taxability of the proceeds for South Carolina income tax purposes.
3. Conclusions of Law
a. Law of Equitable Estoppel
Equitable estoppel is used to prevent a party from proving an otherwise important fact because of something that party has
done or has failed to do. Lee v. Southern Railway Co., 228 S.C. 240, 89 S.E.2d 431 (1955). In general, a party will fall
victim to equitable estoppel when a second party relies upon what the first party has said or done and the second party
changes his position to his detriment. Russell v. Drivers Leasing Services, Inc., 282 S.C. 358, 361, 318 S.E.2d 579, 581
(Ct.App.1984). Such explanation being general at best, case law has developed four specific elements needed to establish
equitable estoppel.
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. (internal cite omitted).
Berkeley Elec. Co-op., Inc. v. Town of Mount Pleasant, 308 S.C. 205, 417 S.E.2d 579 (1992).
However, equitable estoppel (as its name implies) operates in the realm of equity so that its application may vary with the
circumstances under review. For example, case law has developed a specific approach to equitable estoppel as applied to
governmental agencies. In general, the actions of an agent of the government who is operating within the scope of that
agent's authority can give rise to estoppel against the government, but if the action or statements are unauthorized such
actions or statements do not give rise to estoppel. Town of Sullivans Island v. Byrum, 306 S.C. 539, 544, 413 S.E.2d 325,
328 (Ct.App.1992). However, even more specific to the instant case, if the government action sought to be estopped is the
collection of taxes, equitable estoppel "will not be applied . . . to effect public revenues." Heyward v. South Carolina Tax
Commission, 240 S.C. 347, 126 S.E.2d 15 (1962). See Texaco, Inc. v. Wasson, 269 S.C. 255, 237 S.E.2d 75 (1977).
b. Application to Facts
In the instant case, the taxpayer has not established a basis for equitable estoppel so as to prevent the taxation of the funds
here in dispute.
Here, the instant matter is an attempt by DOR to assess and collect income tax by way of an audit. Under such
circumstances, equitable estoppel is simply not applicable. Heyward v. South Carolina Tax Comm., 240 S.C. 347, 126
S.E.2d 15 (1962), Texaco, Inc. v. Wasson, 269 S.C. 255, 237 S.E.2d 75 (1977).
Further, even if equitable estoppel were available, the facts here fail to prove the required elements. For example, the
taxpayer argues that she relied on assurances from agents of the state that the proceeds payable to her would not be taxable.
However, such an allegation cannot be established in light of the pertinent portion of paragraph 5 of the settlement
agreement (signed by the taxpayer) which states the following:
It is expressly understood by the parties hereto that neither the South Carolina Insurance Reserve Fund, the [state agency,
the agency director], nor their counsel have made any representations as to any position or action the Internal Revenue
Service or any other taxing authority might take regarding the payments made hereunder to [taxpayer] and on her behalf,
and [taxpayer] acknowledges and represents that she has relied or will rely solely on the advice of others in this regard.
In the same vein, given the language of paragraph 9 of the agreement, no persuasive evidence establishes that any attorney
for the state made any additional agreement with the taxpayer on the taxability of the funds. Paragraph 9 explains that the
taxpayer understood that the settlement agreement constituted the entire agreement between the parties.
Finally, the taxpayer admits that she never received any statement on taxation of the proceeds from any official of DOR, the
agency most capable of providing information on the taxability of the proceeds for South Carolina income tax purposes.
Indeed, DOR is specifically authorized to give its opinion on the taxability of proposed transactions. See S.C. Code Ann §
12-4-320(2) (DOR may "upon written application, determine the tax effects of transactions and the tax liability of
taxpayers, upon facts furnished to it . . ."). Accordingly, any other person from whom the taxpayer may have perceived that
she was being told the proceeds would be non-taxable would be a person not authorized to make such a determination.
Thus, estoppel would not apply in the instant case. Town of Sullivans Island v. Byrum, 306 S.C. 539, 544, 413 S.E.2d
325, 328 (Ct.App.1992) (actions or statements of unauthorized agents of the state do not give rise to estoppel).
B. Prospective Treatment
1. Positions of Parties
All agree that IRC § 104(a)(2) is the controlling statute in this dispute. However, the taxpayer argues that IRC Section
104(a)(2) should be applied prospectively so that the amendment made in 1996 to that section should not apply to her 1997
tax return. DOR argues that IRC 104(a)(2) is applicable to all income received in 1997 and must be applied to the
taxpayer's 1997 tax return.
2. Findings of Fact
I find by a preponderance of the evidence the following facts:
The taxpayer filed a civil action against a state agency and the agency director in April of 1992 alleging employment
discrimination. She settled that action on December 10, 1997 by executing a settlement agreement ending the matter.
Funds for the settlement were paid to the taxpayer in 1997.
3. Conclusions of Law
IRC Section 104(a) (2) was amended in 1996 with that amendment effective August 20, 1996 and applicable to all funds
received after that date. The amendment allowed the exclusion from income of funds received from personal physical
injuries or physical sickness. South Carolina adopted the amended version of IRC 104(a)(2) when it adopted specific
provisions of the Internal Revenue Code as amended through December 31, 1996. See Act No. 155, 1997 S.C. Acts, Part
II, Section 10.
Along with the substantive provisions of IRC 104(a)(2), South Carolina also adopted the procedural provisions which
explained that the amendments to 104(a)(2) 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. Thus, South Carolina's adoption of
the Internal Revenue Code plainly identified the funds to which the amended law would apply and to which funds the
former law would apply.
In the instant matter, the taxpayer originally filed her civil action in April of 1992, but did not settle her case until
December 10, 1997. Thus, given the language which the General Assembly adopted from the Internal Revenue Code, no
intent exists to extent prospective treatment to funds received by the taxpayer. On the contrary, only funds received under
a written binding agreement, court decree, or mediation award in effect on (or issued on or before) September 13, 1995
could apply the former law. Therefore, given the statute's explicit language, the funds are subject to the amended version of
104(a)(2) and prospective treatment is not appropriate in this case.
C. Physical Injury or Sickness
1. Positions of Parties
The taxpayer argues that the funds paid to her in 1997 were due to physical injury or physical sickness and are therefore not
taxable under IRC § 104(a)(2). DOR, on the other hand, argues the funds paid to the taxpayer were in settlement of a
discrimination suit with none of the damages resulting from a physical injury or sickness. Thus, DOR argues the funds are
fully taxable.
2. Findings of Fact
I find by a preponderance of the evidence the following facts:
Until the end of 1997, the taxpayer was an employee of a state agency. In April of 1992, she filed a civil action in United
States District Court against the director of that agency in the director's individual and official capacities. In addition the
suit named the agency as a defendant. The taxpayer set forth three causes of action in her complaint.
In the first cause of action, the taxpayer alleged she was the victim of sexual discrimination. The basis for that claim is the
allegation that the director failed to allow the taxpayer to "bump into" or apply for specific positions within the state agency
with such director actions based on the taxpayer's sex. The director's actions were alleged to be in violation of the Equal
Protection Clause and to give rise to a remedy under 42 U.S.C. Section 1983.
The second cause of action alleged that the taxpayer was the victim of race discrimination. That discrimination arose due
to the allegation that the agency director "preselected" a "black female employee . . . on the basis of race." The taxpayer
alleged such action gave rise to a violation of 42 U.S.C. Sections 1981, 1983, and 2000e, and the Equal Protection Clause.
The taxpayer's third cause of action, alleged that she was a victim of political discrimination. The allegation is that the
agency director demoted the taxpayer and reclassified her as a part of a political conspiracy and overall plan to get rid of
loyal employees from former administrations. The allegation was that such actions were in violation of the taxpayer's
rights under the First and Fourteenth Amendments and gave rise to a remedy under 42 U.S.C. Section 1983.
Given the violations alleged, the taxpayer asserted in her complain that the actions of the agency and its director produced a
loss of earnings, loss of earning capacity, loss of future retirement benefits, loss of the taxpayer's excellent reputation as a
state employee, loss of self-esteem, mental anguish, emotional distress, and a lesser quality of life.
As a result of her claims, the taxpayer asserted she was entitled to an award of compensatory, special, and punitive damages
and an award of attorney's fees. In addition, she requested that the court award her the position she claimed she was
unfairly denied because of her race.
In preparation for the trial, the state agency deposed the taxpayer and was made aware of the taxpayer's ulcerative colitis
and proctitis. The condition was not an injury or sickness caused by the actions of the state agency toward the taxpayer.
Rather, the condition had been in existence since 1973 and thus predated the taxpayer's disagreement with the state agency.
In treating the colitis and proctitis in 1992, the time of the taxpayer's deposition by the state agency, the taxpayer was able
to control the condition by the use of a sulfur derivative drug in tablet form and a suppository. A maintenance dosage of
the sulfur tablet in 1992 was approximately ten to twelve tablets a day. In addition, the taxpayer took an iron supplement
and a folic acid supplement.
During the period of the lawsuit, the taxpayer remained employed by the agency . She felt ostracized at work and her
superiors assigned her duties requiring extra-long work hours. In fact, on occasions the taxpayer worked eighty hours a
week. However, during the period of the lawsuit, the taxpayer had virtually no contact with the director of the agency.
Rather, contact with the taxpayer came from her superiors and those contacts on occasion produced disagreements. For
example, the taxpayer was challenged by her superiors for allegedly taking unauthorized trips to educational conferences.
During the time period covered by the lawsuit, the taxpayer's colitis worsened. By the time of the 1997 Settlement
Agreement, the taxpayer's maintenance dose of the sulfur derivative tablets had risen to twenty-six tablets a day with the
higher dosage leading to an arthritic condition in her fingers. The taxpayer had frequent episodes of diarrhea and was
hospitalized in 1995 for dehydration During the period leading up to the settlement, the taxpayer also experienced hair loss
and an eye irritation. Following the end of the litigation and the taxpayer's ceasing her employment, the colitis returned to a
manageable condition with a smaller number of sulfur tablets. Further, the hair loss and eye irritation abated.
The resolution of the taxpayer's dispute with the state agency occurred on December 10, 1997. On that date, the parties
entered into a "Settlement Agreement and Release in Full." The agreement provided the South Carolina Insurance Reserve
Fund would pay on behalf of the director of the agency and on behalf of the agency $143,104.84 to the taxpayer and her
attorney; $103,709.64 to the South Carolina Retirement System on behalf of the taxpayer to permit her to retire effective
January 1, 1998, with 30 years of credited service; and $3,185.52 to the South Carolina Retirement System on behalf of the
taxpayer to fund the State share of her health and dental insurance premiums for 1998. In return, the taxpayer released and
discharged all actions against the director and the state agency; the taxpayer voluntarily resigned her employment with the
state agency; and the taxpayer agreed not to apply for employment with the state agency while the agency remained under
the leadership of the then current director.
The taxpayer did not include in income the amount received in the settlement of the lawsuit. On July 12, 2000, DOR sent
the taxpayers an audit report adjusting the taxpayers' 1997 income tax return to include the entire settlement amount in
gross income. DOR allowed the taxpayers a miscellaneous itemized deduction for attorney's fees incurred in the civil
action. As a result, the taxpayers owed additional income tax of $14,025. In addition, the taxpayers owed interest and a
penalty for having made a substantial understatement of tax.
The taxpayers protested the DOR's assessment, and the Department issued a Final Agency Determination on this matter.
That protest resulted in a contested case before the ALJD.
3. Conclusions of Law
a. Physical Injury or Sickness Required for Exclusion
IRC § 104(a)(2) states the following:
(a) In general.--Except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213
(relating to medical, etc., expenses) for any prior taxable year, gross income does not include--
(2) 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;
Further, § 104 explains:
For purposes of paragraph (2), emotional distress shall not be treated as a physical injury or physical sickness.
In general, the issue here is whether IRC § 104(a)(2) and the explanatory language of emotional distress relevant to
paragraph (2) allows the taxpayer to exclude from income the proceeds paid to her as the result of a Settlement Agreement
and Release in Full ending the dispute between the taxpayer and her employer, a state agency. Specifically, the dispute is
whether the taxpayer was paid "on account of" a personal injury or a sickness that was physical with "physical" viewed in
light of the limitations on emotional distress.
b. Identifying the Physical Injury or Sickness
The statute is plain that the payment must be for an injury that is "physical." However, the statute does not affirmatively
state what injuries or sicknesses are "physical" nor is an explanation given on the methodology to be used to determine
when an amount paid can be identified as being for an injury or sickness that is physical. However, two aids are available.
First, legislative history is a proper source for review in deciding what injuries are physical and the means for determining
when a payment is made for a physical injury. Palmetto Lumber Co. v. Southern Ry., 154 S.C. 129, 151 S.E. 279 (1929)
(an adjudicatory body is permitted "to go back to the original act and trace its history, to ascertain the real meaning intended
by the Legislature."). Second, prior case law provides guidance to the extent that those cases address the methodology for
determining what a payment is made "on account of."
1. Legislative History
The pertinent language of House Report No. 104-586, H.R. REP. 104-586 which accompanied the passage of the 1996
amendment to § 104 states the following:
The bill also specifically provides that emotional distress is not considered a physical injury or physical sickness. [FN24]
Thus, the exclusion from gross income does not apply to any damages received (other than for medical expenses as
discussed below) based on a claim of employment discrimination or injury to reputation accompanied by a claim of
emotional distress. Because all damages received on account of physical injury or physical sickness are excludable from
gross income, the exclusion from gross income applies to any damages received based on a claim of emotional distress that
is attributable to a physical injury or physical sickness. In addition, the exclusion from gross income specifically applies to
the amount of damages received that is not in excess of the amount paid for medical care attributable to emotional distress.
(Emphasis added).
FN 24 The Committee intends that the term emotional distress includes physical symptoms (e.g., insomnia, headaches,
stomach disorders) which may result from such emotional distress.
Thus, emotional distress is not a physical injury (even when the distress manifests itself in physical symptoms) if the
damages arise from employment discrimination or injury to reputation. In such circumstances emotional distress will not
result in an exclusion of payment for damages received. However, if the damages arise from a physical injury, all damages
(other than punitive) including the emotional distress damages resulting from that injury are excluded. Accordingly, in the
instant case, the taxpayer's damages (including emotional distress) are excluded if the damages arise from a physical injury
or sickness but the damages are not excluded if the damages arise from a non-physical injury or sickness.
2. The Presence of a Physical Injury or Sickness
Even before the 1996 amendment, taxation or exclusion already depended upon answering an "on account of" inquiry.
That inquiry asked whether the damages were paid on account of personal injury or sickness. The amendment in 1996
merely required that the inquiry also determine whether the damages were paid on account of a physical injury or sickness.
Thus, the "on account of" methodology established by case law for the pre-amendment statute remains relevant to deciding
the post-amendment statute as well.
Deciding what a payment is made "on account of" requires establishing a link between the injury complained of and the
damages recovered. Commissioner v. Schleier, 515 U.S. 323 (1995). That link (or the lack of one) is generally found by
answering "the critical question [of] in lieu of what was the settlement amount paid." Bagley v. Commissioner, 105 T.C.
396, 406 (1995), affd. 121 F.3d 393 (8th Cir.1997).
Finding the basis upon which a settlement is deemed to have been paid cannot be reduced to a mechanical formula that
when applied will answer the "in lieu of" inquiry. Fabry v. Commissioner, 223 F.3d 1261, 1270 (11th Cir.2000), revg. 111
T.C. 305 (1998). Rather, a reasoned approach will involve at least two steps. First, the settlement agreement should be
examined to decide if it expressly states the purpose for which the payment was made and, if it does not, the second step is
to examine all other available evidence to discover the payor's intent in making the payment. Knuckles v. Commissioner,
349 F.2d 610, 612 (10th Cir.1965), affg. T.C. Memo.1964-33; Robinson v. Commissioner, 102 T.C. 116, 126 (1994), affd.
in part, revd. in part on another issue 70 F.3d 34 (5th Cir.1995); Stocks v. Commissioner, 98 T.C. 1, 10 (1992); Laguaite v.
Commissioner, T.C. Memo.2000-103.
a. Settlement Agreement
Here, the settlement agreement states that the payment is made "for the personal injury damages alleged in the Civil Action
and in full and complete settlement of all claims that [the taxpayer] has or in the future may be entitled to have . . ." While
the language teaches that the payment is made for "personal injury," it does not reveal whether the payment is made for a
personal injury that is a physical injury.
Moreover, the agreement encompasses the settlement of current as well as any future claims. For example, the payment
addresses not only the current claim for "damages alleged in the Civil Action," but also future claims. Future claims are
"all claims that [the taxpayer] has or in the future may be entitled to have" against the named state agency. For example,
the settlement language appears broad enough to foreclose future claims by the taxpayer for the tort of the infliction of an
emotional trauma resulting in a physical injury. See Strickland v. Madden, 323 S.C. 63, 448 S.E.2d 581 (Ct. App. 1994)
(elements of tort identified). Further, the settlement language appears broad enough to preclude a cause of action for
emotional distress based on the assertion the state agency's conduct was intentional or reckless. See Ford v. Hutson, 276
S.C. 157, 276 S.E.2d 776 (1981) (tort identified); Holtzscheiter v. Thomson Newspapers, Inc., 306 S.C. 297, 411 S.E.2d
664 (1991) (elements of tort explained). But, in either potential cause of action, facts of the trauma, the means by which
the trauma was inflicted, and the nature of any injury are not identified in the agreement.
Thus, the settlement agreement lacks the specificity to expressly state a purpose that the payment was made to the taxpayer
for a physical injury or physical sickness. Accordingly, the settlement agreement is insufficient to decide in lieu of what
was the settlement amount paid. Thus, any other available evidence must be examined to discover the payor's intent in
making the payment.
b. Evidence of Payor's Intent
Given a settlement agreement that is not decisive, the second step examines evidence available to the payor which may
indicate the payor's intent in making the payment. Such evidence is best examined by reviewing the allegations of the
complaint and the other evidence available to the payor at the time of the payment.
i. Intent from Allegations of Current Complaint
At a minimum, discovering the payor's intent requires weighing the allegations made against the payor in the current
complaint. See Threlkeld v. Commissioner, 87 T.C. 1294 (1986), affd. 848 F.2d 81 (6th Cir.1988); Church v.
Commissioner, 80 T.C. 1104 (1983).
Here, the complaint presents three causes of action which allege political discrimination, race discrimination, and sexual
discrimination. The damages flowing from these allegations are identified in the complaint as loss of earnings, loss of
earning capacity, loss of future retirement benefits, loss of reputation as a state employee, loss of self-esteem, mental
anguish, emotional distress, and a lesser quality of life.
Given the three causes of actions (political discrimination, race discrimination, and sexual discrimination) and the damages
asserted, the payor's intent is not one of making payments for physical injuries. Indeed, the areas for which recoveries were
sought are all traditionally non-physical. See Greer v. United States, 207 F.3d. 322, 328 (6th Cir. 2000) (provides listing of
non-physical injuries including damages for emotions, reputation, or character); see Young v. U.S., 2001 WL 1480296, 88
A.F.T.R.2d 2001-6711, 2001-2 USTC P 50,732 W.D.Ky. Sep 25, 2001 (settlement pursuant to an agreement ending a
discrimination lawsuit in which no party disputed the fact that the injury was non-physical).
When viewed as a whole, the settlement ended an employment discrimination lawsuit. House Report No. 104-586, H.R.
REP. 104-586 which accompanied the passage of the 1996 amendment to § 104 specifically expressed an intent to tax
payments received for " any damages received (other than for medical expenses as discussed below) based on a claim of
employment discrimination or injury to reputation accompanied by a claim of emotional distress." If the taxpayer intended
the lawsuit to be more than an employment discrimination action, that intent was never established. For example, no
specific allegation was made of a physical injury and no cause of action other than discrimination was raised even though
the original complaint was amended on one occasion. Instead, from start to finish, the three causes of action speak to
employment discrimination and the damages asked for are only non-physical injuries. Thus, based on the complaint filed,
the intent of the payor was to pay for an employment discrimination action for which the payment was made for non-physical injuries.
ii. Intent from Other Evidence
As early as 1992, the opposing parties knew of the taxpayer's colitis and proctitis. Further, the settlement language appears
broad enough to foreclose future claims by the taxpayer for the tort of the infliction of emotional trauma resulting in a
physical injury as well as any cause of action for emotional distress due to the agency's conduct being intentional or
reckless. Thus, a reasonable review of the payor's intent examines the evidence to determine if the payment was intended
for damages attributable to physical injury due to the emotional trauma or emotional distress.
- - No Action Filed - -
First, the evidence does not establish that any action was pending by the taxpayer against the state agency or the director for
the infliction of emotional trauma resulting in a physical injury. Rather, only one lawsuit had been filed and that was an
employment discrimination suit. Thus, no suit alleged the specific physical injuries of colitis and proctitis. Therefore, at
the time of payment, the payor had no specific allegations before it upon which one could reasonably conclude that the
payment was made for the taxpayer's colitis and proctitis.
- - No Causal Link - -
Second, and more fatal than the first, no causal link exists between the colitis and the payment of the funds. Commissioner
v. Schleier, 515 U.S. 323 (1995) (exclusion requires establishing a link between the injury complained of and the damages
recovered). At least three observations support this conclusion.
The colitis began as a chronic condition in 1973. The complained of actions of the state agency and the agency director did
not begin until the early 1990's. Plainly, the settlement cannot be a payment for a condition that predated any actions of the
agency or the agency director.
In addition, at best, the evidence shows the existing colitis condition worsened during the years in question. However, no
persuasive evidence establishes a causal link that connects the worsening condition to the actions of the agency or its
director. For example, the evidence establishes that the director had essentially no contact with the taxpayer. Thus the
director's actions do not provide a direct link between the payment and the colitis. Further, while the evidence suggests
that stress is a contributing factor to a colitis "flare up," the evidence does not persuasively establish that the actions of the
agency exacerbated the colitis. Indeed other causes may have been at work. For example, lawsuits are stressful in and of
themselves. The mere fact of filing and pursuing a lawsuit against one's employer while continuing in the employer's
employment may produce a stress inducing environment. Indeed, the taxpayer stated that her colitis had recently become
more of a problem due to the litigation surrounding the instant tax dispute. Therefore, the evidence of a worsening colitis
condition is simply too attenuated to form a causal link to the payment of the funds.
Finally, the House Report previously quoted explains that no exclusion is available for a payment for employment
discrimination "accompanied by emotional distress" even when that distress manifests itself in "physical symptoms (e.g.,
insomnia, headaches, stomach disorders) which may result from such emotional distress." While colitis is not in the list,
the intent is to deny exclusion of payments arising from an employment discrimination case such as the instant case even
when evidence exists that physical symptoms have resulted from the stress created by the employment environment.
Clearly, in the instant case, the taxpayer argues that her colitis resulted from stress which equates to mental anguish and
emotional distress. Accordingly, even if the taxpayer could prove the causal link (which link has not been established) the
supporting legislative history establishes that no exclusion is available.
Therefore, based on all of the above, the funds here in dispute paid to the taxpayer may not be excluded from income under
§ 104(a)(2).
D. Attorneys' Fees
1. Positions of Parties
DOR allowed the taxpayer to deduct as a miscellaneous itemized deduction the amount paid for attorney's fees in the
settlement of the employment discrimination case. However, the taxpayer argues that she should be allowed to exclude the
amount of the proceeds that were paid to her attorney since those funds were not income to her since they were directed to
her attorney.
2. Findings of Fact
I find by a preponderance of the evidence the following facts:
On December 8, 1997, the state tendered a check in the amount of $143,104.84 payable to the taxpayer and her attorney.
The check was a portion of the funds paid to settle a lawsuit for employment discrimination filed by the taxpayer against
the a state agency and the agency's director. Of the $143,104.84, the taxpayer's attorney retained $75,000 for services
rendered in the lawsuit. The remainder was disbursed to the taxpayer.
3. Conclusions of Law
The issue is whether the portion of a settlement payable to a taxpayer's attorney is includable in the taxpayer's gross
income when the funds are paid directly to the attorney by the payor of the settlement proceeds. The majority view is that
the amount paid to the attorney is taxable to the taxpayer but deductible as an expense paid for the collection or production
of income. The Courts of Appeals for the First, Third, Fourth, Seventh, Ninth, and Federal Circuits, and the United States
Tax Court have all held that view. See Kenseth v. Commissioner, 114 T.C. 399 (2000), aff'd, 259 F.3d 881 (7th Cir.
2001); Young v. Commissioner, 240 F.3d 369 (4th Cir. 2001); Coady v. Commissioner, 213 F.3d 1187 (9th Cir. 2000);
Alexander v. I.R.S., 72 F.3d 938 (1st 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 (3rd Cir. 1963). A minority view exists in the Courts of Appeals
for the Fifth and Sixth circuits which hold that funds paid directly to the attorney may not be taxable to the taxpayer under
all circumstances. See Cotnam v. Commissioner, 263 F.2d 119 (5th Cir.1959); Estate of Clarks v. United States, 202 F.3d
854 (6th Cir.2000) (where non-taxability turned on client's contingent fee agreement with the lawyer which agreement
operated as a lien on the portion of the judgment to be recovered and which therefore transferred ownership of that portion
of the judgment to the attorney).
I conclude the majority position to be the better reasoned view. The conclusion has long been 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). Without such a position, a taxpayer could exclude income from
taxation by merely directing a payor to deliver the funds to a recipient in satisfaction of an existing obligation of the
taxpayer. Such a practice cannot be allowed to escape taxation since one having received the benefit of the proceeds (i.e. an
obligation of the taxpayer being satisfied) is taxable on those proceeds without regard to whether the funds are physically
placed in the taxpayer's possession. See Baylin v. United States, 43 F.3d 1451, 1454 - 1455 (Fed.Cir.1995) (where even
though the partnership did not take possession of the funds that were paid to the attorney, it "received the benefit of those
funds in that the funds served to discharge the obligation of the partnership owing to the attorney."). Thus, in the instant
case, the taxpayer's payment to the attorney satisfied an obligation of the taxpayer and thus she received the full economic
benefit of the payment and is taxable on that payment. (1)
E. Penalties and Interest
1. Positions of Parties
DOR assessed a "substantial understatement of tax" penalty pursuant to § 12-54-155(a). The penalty is twenty-five percent
of the amount of the underpayment attributable to the understatement of tax DOR believes that no waiver of the penalty is
warranted since the taxpayer is sophisticated enough to have known that the proceeds should have been reported. Further,
DOR argues that interest is statutorily imposed and may not be waived.
The taxpayer argues the taxability issue was sufficiently in doubt so that she should not be penalized for taking a good-faith
position that the funds were not taxable. Further, she believes the interest is tantamount to a penalty that may be waived.
2. Findings of Fact
I find by a preponderance of the evidence the following facts:
During 1997, the taxpayer received funds as the result of the settlement of a lawsuit. The funds for which the taxpayer
received a benefit were $143,104.84 paid to the taxpayer and her attorney; $103,709.64 paid to the South Carolina
Retirement System on behalf of the taxpayer to permit her to retire effective January 1, 1998, with 30 years of credited
service; and $3,185.52 paid to the South Carolina Retirement System on behalf of the taxpayer to fund the State share of
her health and dental insurance premiums for 1998.
The payor of the funds did not issue a 1099 to the taxpayer and the taxpayer did not include in income any of the amounts
she received in the settlement of the lawsuit. The taxpayer filed a joint return with her husband the husband prepared the
return for filing. The husband is a Certified Public Accountant employed in an accounting practice serving the public.
3. Conclusions of Law
DOR assessed a "substantial understatement of tax" penalty pursuant to § 12-54-155(a). Neither the applicability of the
penalty nor the computation of the penalty is in dispute. Rather, the taxpayer seeks to have the penalty waived and the
interest waived on the additional tax owed.
a. Penalty
A penalty can be waived under the authority of S.C. Code Ann. § 12-54-160 which provides the following:
Unless otherwise specifically prohibited, the department may waive, dismiss, or reduce penalties provided for in this chapter.
Since no prohibition exists on waiving the penalty imposed by § 12-54-155(a), the issue is what grounds exist upon which
to waive the penalty imposed.
South Carolina Revenue Procedure #98-3 provides rational grounds for waiving penalties. In general, a waiver is
appropriate when reasonable cause can be shown. Reasonable cause exists if the taxpayer exercised ordinary business care
and prudence and was nevertheless unable to perform the act required. In light of this criteria, section IV of Revenue
Procedure #98-3 contains a list of examples that may indicate the existence of reasonable cause and may justify the
complete waiver of a penalty. However, the examples are only a guide and the penalty should not be waived if other
factors indicate that the penalty should be imposed.
The taxpayers base their request for penalty waiver on subsection F of Section IV, which provides:
The delay or failure was caused by ignorance of the law in conjunction with other facts and circumstances such as limited
education of the taxpayer or the lack of previous tax and penalty experience. For example, the taxpayer may have
reasonable cause for noncompliance where difficult and complex issues are involved when reasonable persons differ as to
the appropriate tax treatment of the issue and there is no Department guidance with respect to the issue. Also, the taxpayer
may have reasonable cause if the failure was a result of a recent change in law or form revision and the taxpayer could not
reasonably be expected to be aware of the recent change. However, this reason does not include ignorance of the law in
situations where the taxpayer in the exercise of ordinary business care should have been aware of his tax obligations or
consulted a tax advisor.
In this case, reasonable cause exists for the taxpayers' noncompliance with the law. The history of IRC § 104(a)(2) shows a
statute that has been the subject of numerous decisions interpreting the meaning of personal injury. That history shows
disagreement in identifying what payments for injuries are excluded with the dispute involving physical versus non-physical injuries. The amendment in 1996 to IRC § 104(a)(2) was an attempt to limit the exclusion to physical injuries.
However, mental anguish and emotional trauma can manifest themselves physically. The amendment leaves room for
clarification on the circumstances in which the exclusion will and will not apply to injuries resulting from mental anguish
and emotional trauma Thus, a taxpayer could reasonably have concluded (wrongly, but nonetheless reasonably) that the
funds received in the matter presented here were not taxable.
The fact that the taxpayer's husband, joint filer, and preparer is a Certified Public Accountant does not weigh significantly
in favor of maintaining the penalty. Indeed, one with some experience would have been aware of the past history of the
statute. Likewise, the payor did not issue a 1099. Such is some evidence that the amount need not be included in income.
Such is especially true when the payor is the State of South Carolina.
Therefore, reasonable grounds exist to waive the penalty for the "substantial understatement of tax" penalty imposed
pursuant to § 12-54-155(a).
b. Interest
DOR imposed interest on the tax still unpaid by the taxpayer. S.C. Code Ann. § 12-54-25(A) (2000). While statutory
authority exists to waive a penalty, no similar statute authorizes the waiving of interest. The taxpayer suggests that Texaco,
Inc. v. Wasson, 269 S.C. 255, 237 S.E.2d 75 (1977) allows such. I disagree.
In Texaco, the court found that imposing a charge for interest would be inequitable under a unique set of facts:
Texaco had a letter from the respondent's Director of Corporate Income Tax Division, requiring that Texaco file its income
tax return in a certain manner. Texaco followed these instructions explicitly. Whether interest in this case be deemed a
penalty or not, we feel that allowing its collection would be inequitable. The only avenue by which interest could have been
avoided by the taxpayer was for the returns to have been filed using an accounting method contrary to that expressly
ordered by the Commission. We consider the expectation of such conduct on the part of the taxpayer to be unreasonable.
Texaco, Inc. v. Wasson, 269 S.C. 255, 237 S.E.2d 75, 80 (1977). Here it is not inequitable to impose interest. Unlike
Texaco, the taxpayer here was not affirmatively told how to report her income. Thus, no intrusion by the taxing agency
occurred and the manner of reporting the income was a decision within the taxpayer's control. Therefore, the interest is
proper and shall not be waived.
IV. Order
Based upon the facts found and the law as applied to those facts, DOR is not equitably estopped from claiming the
settlement funds received by the taxpayer in 1997 are taxable. Likewise, the 1996 amendment to IRC § 104(a)(2) is
applicable to the taxpayer's 1997 tax year and the funds received by the taxpayer in 1997 are not excluded from taxation
under that statute. In addition, the portion of the taxpayer's funds that were paid to the taxpayer's attorney are included in
her 1997 gross income. Finally, the taxpayer is not liable for a penalty for filing a return that contained a substantial
understatement of tax since that penalty is waived. However, the taxpayer is liable for interest on any unpaid income tax.
AND IT IS SO ORDERED
______________________
RAY N. STEVENS
Administrative Law Judge
Dated: March 28, 2002
Columbia, South Carolina
1. In the instant case, the payment was made to both the taxpayer and the attorney. Thus, the funds did in fact come into the
possession of the taxpayer albeit via a check payable to joint recipients. |