Stadnyk v. Commissioner
367 F. App'x 586 (2010)
Rule of Law:
Under Internal Revenue Code § 104(a)(2), settlement damages are excludable from gross income only if they are received on account of observable physical injuries or physical sickness; damages for emotional distress or loss of liberty arising from false imprisonment, absent physical bodily harm, are taxable gross income.
Facts:
- Petitioners Daniel and Brenda Stadnyk purchased a used car that broke down immediately, leading Brenda to place a stop payment order on a check written to the dealership.
- Bank One incorrectly marked the check as 'NSF' (insufficient funds) rather than 'stop payment' and returned it to the dealer.
- Based on the returned check, the dealer filed a criminal complaint, and Brenda was arrested, handcuffed, detained for approximately eight hours, and strip-searched.
- Brenda testified that she suffered no physical injury, bruising, or pain during the arrest, though she subsequently sought psychological counseling.
- The criminal charges were dropped, and Brenda sued Bank One for negligence, malicious prosecution, false imprisonment, and other torts.
- Bank One settled the lawsuit for $49,000 to avoid further litigation, without specifying the allocation of damages in the settlement agreement.
- Acting on advice from counsel, the Stadnyks did not report the $49,000 settlement as income on their 2002 tax return.
- The IRS determined a deficiency, asserting the settlement funds were taxable income.
Procedural Posture:
- The IRS issued a notice of deficiency to the Petitioners for the 2002 tax year.
- Petitioners filed a petition for redetermination of deficiency with the United States Tax Court.
- The Tax Court ruled in favor of the IRS regarding the tax deficiency but in favor of the Petitioners regarding the accuracy-related penalty.
- Petitioners filed a timely notice of appeal to the United States Court of Appeals for the Sixth Circuit.
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Issue:
Do settlement proceeds received to resolve a claim of false imprisonment and emotional distress constitute taxable gross income under I.R.C. § 61(a) when the taxpayer suffered physical restraint but no resulting physical injury?
Opinions:
Majority - Judge Clay
Yes, the settlement proceeds constitute taxable gross income because the taxpayer failed to demonstrate they were received on account of a physical injury. The Court reasoned that I.R.C. § 61(a) defines gross income broadly to include all accessions to wealth unless specifically excluded. While I.R.C. § 104(a)(2) excludes damages received 'on account of personal physical injuries,' the 1996 amendment to this statute explicitly narrowed the exclusion to require physical injury, thereby making damages for emotional distress taxable. The Court rejected the Petitioners' argument that false imprisonment is a per se physical injury due to the restriction of liberty. Because Mrs. Stadnyk expressly testified that she suffered no physical harm (bruises, cuts, or pain) during her detention, and because the settlement agreement did not allocate funds specifically for physical injury, the damages fall outside the statutory exclusion. Furthermore, the Court rejected the constitutional argument that taxing personal injury compensation violates the Sixteenth Amendment, noting that such a tax is an indirect tax on a transaction/event, not a direct tax requiring apportionment.
Analysis:
This case reinforces the strict interpretation of the 'physical injury' requirement added to I.R.C. § 104(a)(2) in 1996. The Sixth Circuit clarified that the physical act of restraint involved in false imprisonment (handcuffing, jailing) does not automatically equate to a 'physical injury' for tax purposes unless there is actual bodily harm. This decision serves as a warning to legal practitioners drafting settlement agreements: without concrete evidence of physical injury and clear allocation in the settlement agreement, damages for torts involving dignity, liberty, or emotional distress will be treated as taxable income. It also reaffirms the broad scope of I.R.C. § 61(a), placing the burden heavily on the taxpayer to prove they fall within a specific statutory exclusion.
