A version of I.R.C. § 104 — which allows an injured person to exclude from income amounts received as compensation for the physical injury — has existed in the statute in some form or another for nearly 100 years. Until yesterday, however, the Tax Court had never been asked to decide whether the ex-wife of a disabled spouse who was entitled to a share of her husband’s disability payments pursuant to a divorce agreement could exclude the payment from her income pursuant to I.R.C. § 104.
I’ll spare you the suspense: the answer is no.
Shannon Fernandez’ husband worked for the LA Sheriff’s Office for 19 years. He was injured on the job and forced to retire in 1993, at which point he began collecting service-connected disability retirement benefits.
In 1997, the California Superior Court awarded Fernandez a portion of her husband’s disability payments as part of her divorce settlement. During 2007, Fernandez received $12,000 in distributions from the retirement account, which she neglected to include in income on her tax return. The IRS sent a notice of deficiency, assessing $3,500 in tax on the $12,000 of unreported income.
Fernandez argued that in determining the tax treatment of the retirement payment, she should “step into the shoes” of her husband. Since the portion of each payment made to him was undeniably excludable pursuant to I.R.C. § 104 as payments made on behalf of personal injury, and since the divorce agreement required her to receive a portion of her husband’s payments, Fernandez believed she, too, should be entitled to exclude her portion of the retirement benefits.
The Tax Court, after acknowledging that this was an issue of first impression, disagreed, holding that because Fernandez had not suffered her own injury, but rather was receiving payments on account of her ex-husband’s injury, such payments to her were not on account of her personal injury, and thus did not warrant tax-free treatment under I.R.C. § 104.