Post-Settlement Tax Woes Tillman-Kelly

In a recent case from the Tax Court, two married taxpayers failed to establish that their settlement proceeds fell within a statutory exception to taxation.[1] This case is a bit more straightforward than others we may write about from time to time.

Factual Background

In September 2009, Chicago State University (“CSU”) hired Mr. Bryant Tillman-Kelly to act as project director of a federal grant CSU received. After a few months, Mr. Tillman-Kelly expressed concerns to the U.S. Dept. of Education and CSU’s ethics office that grant funds were being misappropriated. Shortly thereafter, CSU terminated Mr. Tillman-Kelly.

Mr. Tillman-Kelly filed suite in the state courts in Illinois for wrongful termination and retaliation relating to his whistleblowing. Mr. Tillman-Kelly sought damages, including those for emotional distress, humiliation, and lost income and benefits. His complaint however failed to allege the suffering of any physical injury. The action was settled in 2017 under a settlement agreement. Mr. Tillman-Kelly received $230,671 with the settlement agreement describing this payment as being for “alleged non-wage injuries, as non-economic emotional distress damages.”

Subsequently, the IRS audited Mr. Tillman-Kelly’s return and after finding this settlement payment was not reported on the appropriate income tax return[2] issued notices of deficiency, assessing additional tax in the amount $67,322 and an accuracy-related penalty of $13,423, all stemming from the settlement payment.

Relevant Law

IRC § 61 states that gross income includes all income from whatever source derived.[3] Exclusions from gross income, however, “must be narrowly construed.”[4] Settlement proceeds constitute gross income unless the taxpayer proves that such proceeds fall within a specific statutory exception.[5] IRC § 104(a)(2) provides the relevant exemption, ultimately (and unsuccessfully) hinged upon by Mr. Tillman-Kelly, stating that “any damages (other than punitive damages) received (whether by suit or agreement…) on account of personal physical injuries or physical sickness” is excepted from gross income. The section further provides that “emotional distress shall not be treated as a physical injury or physical sickness” and the associated regulation explains that “emotional distress is not considered a physical injury or physical sickness” unless it is “attributable to a physical injury or sickness.”[6]

In some cases, like that of the taxpayer in this case, the receipt of payment may not stem from judgment or award by a court. Instead, the payment arises from a settlement. Thus, when a taxpayer receives damages pursuant to a settlement agreement, the nature of the claim that was the actual basis for the settlement controls whether the damages are excludable under § 104(a)(2).[7] The nature of the claim is typically determined by looking to the underlying agreement (in this case, the settlement agreement) to determine whether it expressly states that the damages compensate for personal physical injuries or physical sickness. In the absence of such language, the court inquires as to the intent of the payor.[8] The intent may be determined by taking into account “all the facts and circumstances of the case” including the amount paid, allegations of the injured party, and the factual circumstances leading up to the agreement.[9]


In the present case, the settlement agreement established that the payment was not excludable under IRC § 104(a)(2) as the parties expressly agreed that the $230,671 payment was for “non-wage injuries, as non-economic emotional distress damages.” It is important to note here that the courts will distinguish between emotional distress and physical manifestations of emotional distress. Physical manifestations can be viewed as a physical injury or sickness. Such was not the case in the case presented. The agreement was silent as to any physical injuries or sickness. While the taxpayers did say that the retaliation claim was rooted in an altercation in which a door was allegedly slammed, creating physical injury or sickness, such was never mentioned in the settlement agreement. The Court specifically noted that the settlement agreement “belies the Tillman-Kelly’s position” in that the parties characterized the payment as one for “emotional distress damages” without citing any reference to any physical injury whatsoever. The Court went further, considering going beyond the settlement agreement, which likely would have been dispositive anyway, and looking at the allegation in the state court claim. The claims made were for whistleblower statute, retaliation, and termination, not physical injury. The Court finally found a reference to a physical injury in Mr. Tillman-Kelly’s interrogatory responses in the state court action where the door-slamming was mentioned. Unfortunately, no such reference was made in the original complaint in the state court action or the settlement agreement.


Ultimately, the Court disposed of the case on the plain text of the settlement agreement, holding that the payment was made for “alleged non-wage injuries, as non-economic emotional distress damages.” The Court also noted that even if this failed to answer the question on its face, the state court litigation supports the conclusion as well in that the underlying reason for the payment was emotional distress, unrelated to physical injury.


The case presented should serve as a reminder to be careful with how you frame your claims for damages and settlement agreements. The numbers may be the same, but the characterizations can have far reaching impacts. Iit is likely that this taxpayer would also have to pay tax on the amounts that would be subject to a contingency agreement with their attorney(s). Thus, an award could ultimately result in little to no, or in some cases even negative amounts, received by parties receiving awards or settlement proceeds. The moral of this story is to involve your tax professional in reviewing any substantial settlement amount.

[1] Tillman-Kelly v. Comm’r, T.C. Memo 2022-111.

[2] CSU filed a Form 1099-MISC.

[3] See also Comm’r v. Glenshaw Glass Co., 348 U.S. 426, 429 (1955); Helvering v. Clifford, 309 U.S. 331, 334 (1940).

[4] Comm’r v. Schleier, 515 U.S. 323, 328 (1995).

[5] Id.

[6] Treas. Reg. § 1.104-1(c)(1).

[7] See U.S. v. Burke, 504 U.S.229, 237 (1992).

[8] Devine v. Comm’r, T.C. Memo 2017-111.

[9] Rivera v. Baker W., Inc., 430 F.3d 1253 (9th Cir. 2005).


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