Navigating the Taxability of Defamation Awards

The taxability of compensation for personal injuries unrelated to lost wages or earnings has been a topic of uncertainty, especially after the Murphy decision. The IRS may request the Supreme Court to resolve this issue if it is not successful in the upcoming rehearing of Murphy.

Recently, the Ninth Circuit Court of Appeals solidified its view on the taxability of this type of compensation in the case of Polone v. Commissioner, No.?04-72672 (9th Cir. 2007). The case involved settlement payments received by a terminated employee, which is another Ninth Circuit opinion that addresses the taxability of personal injuries that are unrelated to lost wages or earnings.

Facts & Procedural History

The taxpayer worked as a talent agent at United Talent Agency (UTA) until he was fired on April 21, 1996.

UTA made statements to various entertainment industry publications alleging that the taxpayer was terminated for inappropriate behavior. The taxpayer hired counsel and sent UTA a demand letter alleging that UTA had made defamatory statements. On April 24, 1996, the taxpayer filed a complaint in the Los Angeles County Superior Court alleging wrongful termination and defamation.

The taxpayer and UTA settled both claims on May 3, 1996 whereby the taxpayer received $2 million as settlement of the wrongful termination claim and $4 million as part of the settlement of the defamation claim. The $4 million was paid in four installments of $1 million, which the taxpayer received on May 3, 1996; November 11, 1996; May 5, 1997; and November 11, 1998.

The taxpayer did not include the May 1996 payment on his 1996 federal income tax return, and he did not pay taxes on the May 1997 or November 1998 payments. The IRS sent the taxpayer a deficiency notice for his failure to pay taxes on the settlement payments he received, and the taxpayer petitioned for review in the U.S. Tax Court.

Taxability of Settlement Payments

The Tax Court and the Ninth Circuit Court of Appeals ruled that the first installment payment that the taxpayer received as part of his settlement payment was not taxable. However, the last three installment payments were found to be taxable, and the taxpayer’s argument that the entire settlement payment was not taxable due to the agreement being finalized before Congress amended Section 104 was not successful.

The Ninth Circuit Court based its decision on the fact that California law does not allow for the transfer of defamation claims. Therefore, the court found that the taxpayer was selling his right to sue for defamation in incremental sales, with each sale being made at the time an installment payment was received. The court held that the payments would have been tax-exempt if the taxpayer had entered into a formal agreement eight months prior to the settlement agreement, fitting into the grandfather exclusion provision set out in the amended Section 104.

The Constitutional Challenge

The taxpayer argued that it was unconstitutional for Congress to enact a tax law that changes the tax consequences for his settlement agreement. He contended that Section 104, as amended, amounted to retroactive legislation that violated his Fifth Amendment due process rights.

The Ninth Circuit Court rejected his argument, stating that the last three installment payments did not arise until after Section 104 was amended. This case is another Ninth Circuit opinion that has upheld the taxability of personal injuries that are unrelated to lost wages or earnings.

The court did not address the direct question of whether Section 104 is constitutional, which was challenged in the Murphy decision, as the taxpayer in the present case did not specifically raise that issue.

The Takeaway

This case involves the taxability of settlement payments received by the taxpayer after he was terminated by his employer. It is not a case of physical injuries or sickness excluded under Section 104. The U.S. Tax Court and the Ninth Circuit Court of Appeals held that the last three installment payments were taxable, but the first payment was not. The Ninth Circuit Court rejected the taxpayer’s argument that the entire settlement payment was not taxable due to the agreement being finalized before Congress amended Section 104. The court also rejected the taxpayer’s argument that Section 104, as amended, was unconstitutional. This case is yet another Ninth Circuit opinion that has upheld the taxability of personal injuries that are unrelated to lost wages or earnings.