## Facts

- Hi Life Products, Inc., a closely held corporation formed in 1976, manufactured urethane foam carpet padding.
- Peter E. Maxwell (president/general manager) and Helen E. Maxwell (executive vice president/secretary/treasurer) each owned 47.5% of the corporation; two additional shareholders owned the remaining 5% and were also officers.
- The corporate officers elected to exclude themselves from California workers’ compensation coverage to reduce premiums.
- In 1977, Peter suffered serious physical injuries while operating a mixing machine during his employment with Hi Life.
- After consulting corporate counsel about potential liability and obtaining independent counsel, Peter asserted a personal-injury claim against Hi Life and made a written settlement demand.
- Hi Life’s board considered the claim with advice from its own counsel; Peter recused himself from the board’s deliberations.
- The parties executed a written settlement agreement under which Hi Life paid Peter $122,500.
- Hi Life deducted the $122,500 as an ordinary and necessary business expense under I.R.C. § 162(a).
- Peter and Helen did not report the payment as income, treating it as excludable damages for personal injuries under I.R.C. § 104(a)(2).
- The Commissioner disallowed Hi Life’s deduction and included the payment in Peter’s income, characterizing the payment as a disguised dividend.

## Issues

1. Whether Hi Life could deduct the $122,500 payment as an ordinary and necessary business expense under I.R.C. § 162(a).
2. Whether Peter could exclude the $122,500 from gross income as damages received on account of personal injuries under I.R.C. § 104(a)(2).
3. Whether, in substance, the payment was a bona fide tort settlement or a nondeductible corporate distribution to a controlling shareholder.

## Decision

- The Tax Court held the $122,500 payment was made to settle a bona fide personal-injury claim and was not a disguised dividend.
- The court allowed Hi Life a deduction for the payment under § 162(a).
- The court held Peter could exclude the payment from gross income under § 104(a)(2).
- The Commissioner’s deficiency determinations were rejected to the extent they depended on dividend treatment of the payment.

## Legal Principles

- A payment made to settle a bona fide tort or personal-injury claim arising from business operations may qualify as an ordinary and necessary business expense deductible under I.R.C. § 162(a).
- Amounts received as damages on account of personal physical injuries may be excluded from gross income under I.R.C. § 104(a)(2) (as then in effect) when the payment is paid in settlement of that injury claim.
- In determining whether a payment from a closely held corporation to a shareholder is a dividend or a liability-driven settlement, the court looks to substance, including the existence of a credible claim, liability exposure, adversarial negotiations, separate legal representation, and corporate decision-making procedures (e.g., board deliberation and recusal).

## Conclusion

The Tax Court concluded that Hi Life’s $122,500 payment to its controlling shareholder-employee resolved a genuine workplace personal-injury claim; accordingly, the corporation could deduct the payment under § 162(a), and the recipient could exclude it from income under § 104(a)(2), rather than treating it as a disguised dividend.


Maxwell v. Commissioner, 95 T.C. 107 (1990)