Two Tax Court Decisions That Clarify What Counts as Taxable Income
Tax law reaches into almost every corner of life, from settlements that compensate someone for an injury to retirement accounts that are lost through legal action. I find that reading about unusual cases is one of the best ways to understand how the Internal Revenue Code defines income. Two recent decisions highlight that definition in very different ways.
Zajac v. Commissioner – A Settlement Partly Excludable from Income
In Zajac v. Commissioner, T.C. Memo. 2025-33, Joseph Zajac received a settlement of $35,001 from a Massachusetts town following a civil rights lawsuit that included claims of physical injury and emotional distress. The Internal Revenue Service asserted that the entire amount was taxable. The Tax Court disagreed in part, holding that one-half of the settlement was excludable under Internal Revenue Code Section 104(a)(2) because it compensated Zajac for physical injuries and the resulting distress. The remaining half was taxable because it related to nonphysical damages.
The Court emphasized that the deciding factor is what the payer intended to compensate, not what the taxpayer believed the payment represented.
What this means in practice
Whenever a client receives or negotiates a settlement, the wording of the agreement can determine whether a portion is excluded from income. Section 104 allows exclusion only for damages received on account of personal physical injuries or physical sickness. The Internal Revenue Service provides a good summary of Tax implications of settlements and judgments.
The Zajac decision is a reminder that the tax outcome often depends more on careful documentation than on the size of the payment.
Hubbard v. Commissioner – When an IRA Forfeiture Was Not Income
The second case comes from the Sixth Circuit Court of Appeals, which reversed a Tax Court ruling involving criminal forfeiture of a retirement account. In Hubbard v. Commissioner, No. 24-1450 (6th Cir. 2025), the taxpayer’s individual retirement account was seized by the government after a criminal conviction. The Internal Revenue Service treated the seized balance as a taxable distribution under Section 408(d)(1), claiming the taxpayer had “constructively received” the funds.
The Sixth Circuit disagreed. The court reasoned that when the government became the legal owner of the IRA through forfeiture, the taxpayer did not receive or control the money. Because the taxpayer was neither the payee nor receiver, there was no taxable distribution under Section 408.
Broader Takeaways
Documentation governs taxation. Whether through settlement agreements or retirement account custodians, the paper trail defines what the IRS sees as income.
Intent matters. Courts continue to look at the payer’s intent and statutory language when deciding what is taxable.
Tax law evolves through examples. These cases are not everyday situations, but they reveal how courts interpret the boundary between taxable and nontaxable receipts.
Schedule a Consultation
Complex tax questions often arise from unexpected situations, especially when legal agreements are involved. If you are negotiating or finalizing a complicated legal matter, be certain that your CPA is aware and actively involved. Careful coordination can help you craft the most tax-advantageous agreement for all parties.
If you wish to discuss how recent Tax Court decisions or IRS interpretations may affect your planning, I welcome you to schedule a consultation. I will examine your situation carefully and translate complex rules into practical strategies for you.
