In 2018 Mr. Keenan received $70,966 from Rancho Santa Fe Association pursuant to a settlement agreement. Keenan was employed as a ranch manager by the company. The settlement agreement stated the payout was for “emotional stress damages” and continued to pay Keenan’s healthcare premiums. In return, Keenan dropped his employment discrimination lawsuit. The IRS audited Keenan’s tax return, arguing that the payment was taxable non-employee compensation. Keenan argued the payment should be characterized as “damages received on account of personal physical injuries or physical sickness” which under IRC § 104(a)(2) are excludable from income.  

When damages are received pursuant to a settlement agreement, the nature of the claim that was settled determines whether the proceeds are taxable. Even though the settlement agreement referenced emotional distress damages, the court found that the settlement payment was made to settle an employment dispute and was not payment that went towards medical care for emotional distress. The IRS’s determination was correct, and the payment was taxable income.

Keenan v. IRS, T.C. Memo 29299-21S (June 12, 2023).