Debra Jean Blum filed a lawsuit that clearly dealt with physical injuries she sustained, but which she claimed her attorneys had bungled—so she then filed suit against the law firm. This dispute was settled out of court, and Debra sought to claim that this settlement was excludable from income as damages received on account of personal physical injuries under IRC §104(a)(2).[1]

IRC §104(a)(2) provides:

(a) In general

Except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical, etc., expenses) for any prior taxable year, gross income does not include—

…

(2) the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness;

Original Lawsuit Against the Hospital

The opinion describes Ms. Blum’s original case and the failure of this case in court:

In August 2007 Ms. Blum was admitted to Our Lady of Lourdes Hospital in Pasco d.b.a. Lourdes Health Network (hospital) for total left knee replacement surgery. While there, Ms. Blum allegedly suffered personal injuries after being directed by an admissions clerk to sit in a wheelchair, which turned out to be broken. When Ms. Blum attempted to sit in the wheelchair, she allegedly fell on the floor and sustained significant injuries.

In March 2008 Ms. Blum retained an attorney to represent her in a suit against the hospital. The attorney filed a complaint in July 2010 in Washington State court, alleging that the hospital: (1) “was negligent in its care, moving, transportation and treatment of * * * [Ms. Blum] causing her to fall and sustain severe injuries” and (2) “failed to properly direct, supervise and prevent the contact of its other agents and employees * * * and was therefore negligent.”

While the lawsuit was pending, Ms. Blum’s attorney retired from the practice of law and withdrew as her attorney of record. Ms. Blum retained another attorney from the same law firm to continue the representation. In September 2011, however, the trial court granted summary judgment to the hospital. Ms. Blum appealed the case pro se, but the Washington State Court of Appeals affirmed the trial court’s decision.[2]

Had Ms. Blum been successful in being compensated in this case, the damages received would very likely have qualified for exclusion from income under IRC §104(a)(2), as the issue was clearly related to physical injuries that Ms. Blum suffered.

Settlement with Law Firm Regarding Representation in Physical Injury Case

Ms. Blum was upset with the firm’s representation of her in that failed case, and she filed a lawsuit against the attorneys:

In June 2014 Ms. Blum brought a malpractice suit against her former attorneys in Washington State court, alleging that they had breached their duty of care in failing to properly prosecute her lawsuit against the hospital. In her complaint Ms. Blum alleged that her physical injuries were caused “solely by the negligence and/or fault of * * * [the hospital] and its employees” and that she “would have prevailed in * * * [her claim against the hospital] but for * * * [her former attorneys’] breach of the standard of care.” In her prayer for relief Ms. Blum asserted that her former attorneys’ representation “fell below the standard of care expected of a Washington attorney” and that she “sustained damage because of * * * [their] breaches of the standard of care.” She did not allege in her complaint that she had suffered any physical injuries for which her former attorneys should be responsible, nor did she seek compensation for any physical injuries.

The parties settled the malpractice lawsuit in June 2015 with Ms. Blum agreeing to drop any and all claims against her former attorneys “related to or arising out of * * * [their] representation of Blum in * * * [her claim against the hospital]” in exchange for a payment of $125,000. The parties’ settlement agreement expressly stated that it was “entered into by the Parties for the purpose of compromising and settling the dispute between them”, which the agreement described as a “malpractice claim”. The settlement agreement further provided that “Blum maintains, and * * * [her former attorneys] do not dispute, that Blum [*5] did not sustain any physical injuries as a result of the alleged negligence of either * * * [of her former attorneys]” and that “Blum’s physical injuries are * * * alleged to have resulted from the * * * [hospital] incident, which did not occur as a result of any fault or negligence by * * * [her former attorneys]”.[3]

Ms. Blum did not include this payment in her income, arguing that the $125,000 represented the law firm paying her the damages for her physical injury that she claimed their malpractice prevented her from receiving.

Nature of the Damages Received Were Not for Physical Injuries

Unfortunately for Ms. Blum, the Tax Court did not determine that it should project this award back as compensation for Ms. Blum’s physical injuries. Rather, the Court looked at the particular lawsuit for which Ms. Blum received the payment.

The Court explains why it does not look beyond the particular agreement under which the damages were paid:

Ms. Blum counters that the payment was received “on account of personal physical injuries or physical sickness” because “but for” her former attorneys’ allegedly negligent representation, she “would have received damages from the hospital * * * [which] would be * * * excludable under section 104(a)(2).” Both we and the Court of Appeals for the Ninth Circuit have explained, however, that a taxpayer “must show that there is ‘a direct causal link between the damages and the personal injuries sustained.’” Doyle v. Commissioner, at *11 (quoting Rivera, 430 F.3d at 1257).[4]

The opinion notes that the agreement itself provides what the compensation relates to:

In the settlement agreement the parties made clear that the amount paid was not directly linked to the personal injuries suffered by Ms. Blum. According to the settlement agreement the nature of the claim for which Ms. Blum was compensated was legal malpractice, which plainly lies outside the scope of section 104(a)(2).[5]

The Court refused accept Ms. Blum’s view that the law firm intended to compensate her for her physical injuries:

Ms. Blum further argues that her former attorneys actually intended to compensate her for the physical injuries she allegedly sustained at the hospital. The settlement agreement dooms her contention. Even if we looked outside that agreement, the complaint filed against the former attorneys related only to legal malpractice and described damages stemming from such malpractice. There is simply no support for Ms. Blum’s attempt to recharacterize her suit or settlement.[6]

Payment Was not a Return of Capital

Damages received that are meant to be a recovery of capital (such as reimbursing for a car destroyed by the defendant in an auto accident) are also excludable from income. Ms. Blum argued, in the alternative, that this payment was just that—the law firm was replacing the tax-free funds she would have received except for their malpractice.

But the Court did not accept this view either:

The purported loss that she claims was the amount that she might have received from winning her personal injury lawsuit, which strikes us as a highly speculative proposition. Moreover, Ms. Blum fails to convince us that the settlement payment was meant to replace this purported loss, rather than for any of the other reasons that might have prompted her former attorneys to settle. In short, we do not view her recovery in the malpractice case as restoring her capital but instead as compensating her for distinct failings by her former lawyers. Consequently, this amount is not a recovery of capital and is includable in her gross income.[7]

[1] Blum v. Commissioner, TC Memo 2021-18, February 18, 2021, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/settlement-for-malpractice-in-personal-injury-suit-was-income/2zf0m (retrieved February 20, 2021)

[2] Blum v. Commissioner, TC Memo 2021-18

[3] Blum v. Commissioner, TC Memo 2021-18

[4] Blum v. Commissioner, TC Memo 2021-18

[5] Blum v. Commissioner, TC Memo 2021-18

[6] Blum v. Commissioner, TC Memo 2021-18

[7] Blum v. Commissioner, TC Memo 2021-18