Protecting Client Interests Through Careful Drafting of Settlement Agreements For Personal Injury Cases

Imagine that you finally schedule that meeting to sign the settlement agreement and pick up the settlement check. But wait… did you know that the language in the settlement agreement can have drastic effects on the amount of money that you have to report to the I.R.S.? Don’t settle for vague drafting!

Congress intended for Section 104(a)(2) to alleviate the tax burden of taxpayers who suffered a personal injury and received money as a result of tort litigation. Section 104(a)(2) states that notwithstanding deductions allowed under Section 213 for medical and other expenses, “gross income does not include … 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.”

In Jon E. Hellesen v. Commissioner, the Tax Court gave deference to the language in the settlement agreement, notwithstanding the court’s concerns regarding whether an actual physical injury occurred. Mr. and Mrs. Hellesen, both fired State Farm employees, claimed extreme and severe emotional distress, including lack of concentration, loss of self-esteem, embarrassment, anxiety, humiliation, and stress. Mr. Hellesen also claimed physical problems due to being fired, including chest pain, aching pain and loss of sensitivity on the right side of his forehead, increased blood pressure, weight loss, upset stomach, irregular bowel movement, headaches, and emotional instability. Mr. Hellesen visited two physicians one time each, with neither providing a diagnosis or proof of medical expense.

The court noted that no physical injuries or sickness were alleged in the original complaint, and therefore, it appeared as if the claim was merely for emotional distress. Because the settlement agreement did not allocate any portion of the amount among the claims, the court held section 104(a)(2) inapplicable.

In Emblez Longoria v. Commissioner, a New Jersey State Trooper alleged racial discrimination and physical injuries. He based his physical injuries on being forced to inhale noxious chemicals during a training exercise, and for falling ill due to being singled out to perform extra laps in the swimming pool. Mr. Longoria also suffered injury when restraining a suspect while co-workers ignored his request for backup, and opening a locker that had been secretly piled high with gear from other troopers.

The court again looked to the settlement agreement in determining the applicability of section 104(a)(2). In Longoria, the settlement agreement was extremely plain, with an all-purpose release but providing legal language regarding the allocation of payments for tax purposes. Because the settlement gave no regard to how much of the payment was for racial discrimination and how much was for physical injuries, Mr. Longoria received a lump sum of $156,667.00 and a Form 1099. When Mr. Longoria sought to exclude the entire amount, the I.R.S. challenged the deduction.

The court noted that Mr. Longoria clearly did experience various physical incidents and some physical injuries, however, these injuries were not alleged in his complaint. Because Mr. Longoria could not overcome the burden of proving what damages were paid on account of physical injuries or physical sickness, the entire lump sum was treated as taxable.

In Hartford and Josephine Shelton v. Commissioner, the Plaintiff suffered sexual harassment while employed by Dial Corporation. Due to the harassment, Ms. Shelton developed several emotional problems and sought medical help. She took anti-depressants and other various medications, and later filed a claim with the EEOC. Later, she signed a release and received $123,500. She was issued a Form 1099 for the entire amount, and claimed the entire amount as excludable under section 104(a)(2).

The Court held that her settlement payment was not excludable because the settlement agreement stated that the money was for emotional pain, suffering, inconvenience, and mental anguish, making no mention of physical injury. Although the record reflected that Ms. Shelton suffered physical injury as a result of her sexual harassment, the actual settlement agreement made no mention of physical injury.


It is in the best interests of all parties involved to ensure that settlement provisions are clear regarding the basis for the payment to avoid unnecessary litigation expenses. While some defense attorneys may be tempted to draft a blanket release along with a Form 1099 under the belief that further responsibility lies with the Plaintiff to determine tax liability, this approach overlooks the reality that if the I.R.S. questions the excludability of the Plaintiff’s amount, then both parties will be required to provide time and energy to resolve the dispute.

Counsel should not rely on such treatment and outline all settlement terms explicitly. The most important tool to avoid post-settlement litigation is a well-drafted settlement agreement. The agreement must contain a clear statement regarding the nature of the payment. In the case of multiple payments, defense counsel should issue separate checks for amounts based on compensation and amounts paid on account of physical sickness or physical injury. The accompanying Form 1099 should match the excludable amount, giving evidence of the payor’s intent. As a best practice, defense counsel should also issue separate payment for plaintiff’s counsel, and that amount should not be included on the Form 1099 because it will not be received by the Plaintiff.

Plaintiff’s counsel must include claims of physical sickness or physical injury to ensure that they meet the requirements of section 104(a)(2). If the original complaint alleges only discrimination, for example, and that emotional injury later manifests into a physical injury, the court will not find excludability under section 104(a)(2).

As with all well-drafted contracts, counsel would be well-advised to bar parol evidence and state explicitly that the contract is a final integrated writing, which contains all of the terms agreed upon by the parties. Counsel should also include a merger clause stating that any previous negotiations will be superseded by the final contract. These clauses act to limit the scope and discovery of potential post-settlement litigation.

While this general advice seems obvious, the above cases became tax disputes because defense counsel drafted only an all-inclusive release of claims, and included a blank Form 1099 and a settlement check. In turn, plaintiff’s counsel advised his or her client to sign such a release. Protecting the client’s interests requires an attorney to look beyond the immediate transaction with an eye toward potential litigation to follow. With recent court decisions giving attorneys a glimpse into the factors that will be considered, anything less than careful drafting falls short of professional and ethical representation. It can also result in the loss of thousands of dollars! Insist on language in the settlement agreement that protects your tax exclusion!

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