San Francisco Sexual Harassment Settlement Is Taxable Event

The United States Tax Court has ruled that the proceeds from the settlement of a sexual harassment lawsuit is considered to be income, and thus subject to federal income tax. The case involved a San Francisco firefighter who filed suit in 2017, and settled in 2018.

The facts as explained by the court are as follows:

• This case is about a settlement received by a woman named Suzanne Montes.
• Ms. Montes was a pioneer for women in the San Francisco Fire Department and wanted to be a firefighter since she was a little girl.
• Back in 2016, she received a coveted assignment to a firehouse in downtown San Francisco.
• This unit has particularly difficult chores of securing the roof of a building burning, perhaps venting gases to allow suppression of the fire; it’s extremely dangerous work, and of course it requires the members of the team to be able to trust each other and work together.
• The other members of her team, at least many of them, did not welcome her.
• Within weeks, even days of the start of her tenure in the firehouse in downtown San Francisco, some of the male firefighters began making disparaging comments about her, sabotaged her equipment, making it difficult for her to speedily respond to calls.
• Ostracized her within the firehouse, and escalated into doing disgusting and extremely unsanitary things to her personal property.
• She complained to the chiefs within the firehouse itself, which only served to increase the harassment she was suffering from.
• She made complaints to higher authorities.
• Finally, in 2017, it led to her decision to file a lawsuit in Federal court to put an end to the harassment, and in June of 2018, that lawsuit was settled.
• We’re here in Tax Court because of one of the terms of the settlement.
• One of those terms was a payment to Ms. Montes of $382,797.70 to her personally.
• The agreement also provided for attorney’s fees, but that’s not at issue here.
• The agreement was approved, and the payment was made and received in 2018.
• Ms. Montes returned to work and continues to this day as a firefighter working for the people of the City of San Francisco.

At issue in the case is whether the $383k payment is income for income tax purposes. As a general rule, “settlement proceeds” are not considered to be income provided they are paid as a result of personal injuries or personal sickness. On the other hand, payments for lost wages would be taxable.

The settlement agreement between Montes and the city characterized the payment as being “general damages for personal injury, including allegations of emotional injury. This amount will not be considered or treated as back wages.” Based upon this, Montes’ accountant advised her that the settlement was not taxable.

The IRS disagreed, noting that despite the obvious statement in the settlement agreement, Montes’ complaint did not allege either personal injury or property damage. The court noted that per the IRS Code, emotional distress is not considered to be a personal injury for income tax purposes. Quoting from the decision:

• There are no allegations of physical injury to Ms. Montes, and indeed, in the summary of the complaint it says, “She has lost compensation for which she would have been entitled. She has suffered from emotional distress, embarrassment, and humiliation and her prospects for career advancement have been diminished.”
• She sought compensatory damages, including future wages, employee benefits, and damages for mental and emotional distress, damage to her reputation, and humiliation.
• There are no allegations of physical disease or harm to her in the complaint.
• This leads to the next question, which is, is alleged emotional distress a personal physical injury or physical sickness?
• Here, the Code tells us that it isn’t. Section 104(a) specifically commands that “emotional distress shall not be treated as a physical injury or physical sickness” and case law tells us that emotional distress includes symptoms such as insomnia, headaches, and stomach problems that result from such severe emotional distress.
• I can’t fault Ms. Montes for the position that she took, but section 104 says that this payment has to be included in her taxable income.
• Certainly, she wouldn’t have had to pay a penalty. She took a reasonable position on the advice of a CPA.

Here is a copy of the decision: