## Facts

- Laura Stepp, a Transportation Security Administration employee, suffered a serious on-the-job shoulder injury and received federal workers’ compensation.
- After returning to work, she was involuntarily reassigned from baggage screening to passenger screening and sought to remain in baggage screening with accommodations for her physical limitations.
- She filed an administrative EEO complaint alleging discrimination, harassment, retaliation, and hostile work environment based on workplace treatment following her injury and accommodation requests.
- The administrative findings concluded the agency retaliated against her and subjected her to a hostile work environment causing emotional harm and stress; they did not find any new physical injury caused by the unlawful conduct.
- Stepp entered a settlement resolving the EEO matter that provided $121,500 plus non-monetary relief (including reassignment and personnel-file corrections).
- The settlement agreement did not allocate any portion of the payment to compensation for personal physical injuries or physical sickness.
- On the joint return for the year received, the taxpayers treated the $121,500 as effectively excludable as personal-injury damages; the IRS determined the amount was taxable and issued a deficiency.

## Issues

1. Whether the $121,500 paid to settle an administrative EEO dispute is excludable from gross income under I.R.C. § 104(a)(2) as damages received on account of personal physical injuries or physical sickness.

## Decision

- The Tax Court sustained the deficiency determination.
- The court held the settlement proceeds were not excludable under § 104(a)(2) and were fully includible in gross income.
- The court found the payment was made in settlement of discrimination/retaliation and hostile work environment claims causing emotional distress, not on account of physical injury or physical sickness.

## Legal Principles

- I.R.C. § 104(a)(2) excludes damages from gross income only if received on account of personal physical injuries or physical sickness (punitive damages excluded from the exclusion).
- The “nature of the claim” controls the tax characterization of settlement proceeds; courts determine what the payment was made “in lieu of” by examining the underlying allegations, administrative findings, and the settlement terms.
- Emotional distress damages are generally taxable under § 104(a)(2) after the 1996 amendment adding the “physical” requirement; physical symptoms associated with emotional distress do not, by themselves, convert the damages into payments for physical injury or sickness.
- The taxpayer bears the burden to show the settlement was intended to compensate for physical injury or physical sickness; a settlement agreement’s silence or lack of allocation to physical injury weighs against exclusion.

## Conclusion

Because the administrative record and settlement documents showed the payment resolved EEO discrimination and retaliation claims with emotional-distress harms, and did not compensate for a physical injury or physical sickness caused by the challenged conduct, the Tax Court held the $121,500 settlement was taxable and not excludable under I.R.C. § 104(a)(2).


Stepp v. Commissioner, T.C. Memo. 2017-191 (2017)