INCOME TAXATION OF EMOTIONAL DISTRESS IN PERSONAL INJURY ACTIONS

by Thomas D. Begley, Jr., CELA

General

As a general rule, recoveries in personal injury actions are excluded from federal income tax only if they result from a physical injury or physical sickness. The Internal Revenue Code specifically states that “emotional distress shall not be treated as a physical injury or physical sickness.”[1] Emotional distress might include such symptoms as insomnia, headaches, stomach disorders, etc. However, damages for emotional distress would be excludable if they flowed from a related physical injury.

The exclusion under § 104 covers damages arising from tort or tort-like claims, as well as Worker’s Compensation claims. In a Worker’s Compensation claim, personal injuries are sufficient. Physical injuries are not required[2] as they are in tort-based claims.[3]

Stress-Induced Physical Ailments

What about a situation where a plaintiff suffers emotional distress that induces physical ailments? The tax court has indicated that recovery may be tax free where (1) the taxpayer can demonstrate that the damages were actually received on account of those ailments, and (2) the physical nature of the ailments was verified by a physician, preferably based on objective medical evidence rather than the taxpayer’s subjective report of symptoms.[4]

In the Blackwood case, the taxpayer did not satisfy this standard. In a subsequent case, the tax court held that § 104(a)(2) applied to damages that the taxpayer received on account of heart attacks and cardiovascular damage that he suffered due to intentional infliction of emotional distress at his workplace.[5] The tax court concluded that the taxpayer’s physical ailments were not “symptoms” of emotional distress. The court emphasized that in medical parlance a “symptom” is subjective evidence of disease or of a patient’s condition, i.e., such evidence as perceived by the patient. The court viewed the taxpayer’s ailments in this case as actual “physical injury or sickness rather than mere subjective sensations or symptoms of emotional distress.” It would appear that the taxpayer would have to show that the ailments were objectively verified by a physician based on signs of illness other than the taxpayer’s subjective report of symptoms, and that the taxpayer can demonstrate that the damages were paid on account of the physical ailments. The difference between Parkinson and Blackwood is that it is critical to obtain a medical diagnosis during the underlying dispute and emphasize diagnosed physical ailments in communications with the defendant.

Maximizing the Medical Care Exception

Although generally emotional distress claims are taxable, plaintiffs can deduct from income any medical care expenses incurred as a result of emotional distress for which plaintiff is being compensated, so long as the expenses were not previously deducted. The issue relates to future medical expenses. The problem is if the plaintiff receives a lump sum as compensation for future medical expenses under a taxable emotional distress claim, the tax would be due at the time the monies were received. The plaintiff may not be able to take advantage of a medical deduction in subsequent years as medical expenses are incurred and paid for. The taxpayer would be better served by postponing receipt of the taxable income for future medical expenses until those expenses are actually incurred. The device to achieve this result would be a structured settlement. If the client expects to incur $20,000 of medical care expenses annually for 20 years and receives $400,000 upfront, the client would be in the highest tax bracket for that year. The medical expense would only be available to the extent that the medical expenses exceed 10% of the client’s gross income. If the same client structured the payment so as to receive $20,000 per year for 20 years, the medical deduction will offset most, if not all, of the annual payment. In a Private Letter Ruling, the IRS allowed a plaintiff to postpone the receipt of emotional distress damages, for tax purposes, by structuring her settlement.[6]

Non-Taxable Emotional Distress Damages

Emotional distress damages may be non-taxable if:[7]

• The claimant’s emotional distress resulted from the claimant’s physical injuries or physical sickness; or
• The claimant’s emotional distress resulted from another person’s physical injury or physical sickness; or
• The damages compensate the claimant for expected medical expenses; or
• The emotional distress was so significant that it caused physical ailments observable by a doctor, i.e., a heart attack.

Personal Injury Not Involving Physical Injury or Sickness

A whistleblower, Mrs. Murphy, was fired from her job and brought suit alleging that she had suffered from physical manifestations of stress as well as damage to her reputation. She was awarded $70,000: $45,000 for “emotional distress or mental anguish” and $25,000 for “injury to professional reputation.” Mrs. Murphy took the position that the amended I.R.C. § 104(a)(2) requiring a physical injury was unconstitutional. The U.S. Court of Appeals at first agreed, but then on rehearing held that damages for personal injuries were included in the definition of gross income under I.R.C. § 61 and held I.R.C. § 104(a)(2) to be constitutional.[8]

Political Discrimination

Damages flowing from an action for political discrimination are taxable.[9] In the Ruffin case, the petitioner sued the City of Chicago for repeatedly turning down her job applications. She joined a class action suit and received a $12,500 settlement. The petitioner argued that the settlement payment was not wages since she never worked for the city, but was for the city’s violations of law, and was for political discrimination and as such shouldn’t be taxed. The IRS held that the only way a payment could be excluded from income is if it is made for physical injuries or physical sickness.

Post-Traumatic Stress Disorder

There is a question as to whether a recovery for Post-Traumatic Stress Disorder (PTSD) is taxable. The issue is really medical. Is PTSD merely a mental state or is it a physical sickness involving measurable changes in the physical make-up of the brain and nervous system? To date, the question is unresolved.

[1] I.R.C. § 104(a)(5).

[2] I.R.C. § 104(a)(1).

[3] I.R.C. § 104(a)(2).

[4] Blackwood v. Commissioner, T.C. Memo 2012-190.

[5] Parkinson v. Commissioner, T.C. Memo 2010-142.

[6] Priv. Ltr. Rul. 2008-36-019.

[7] Parkinson v. Commissioner, T.C. Memo 2010-142.

[8] Murphy v. IRS, 493 F.3d 170, 2007-2 U.S. Tax Cas. (CCH) P50531, 46 A.L.R. Fed. 2d 783 (D.C. Cir. 2007).

[9] Ruffin v. Commissioner, T.C. Summary Opinion 2011-136 (Dec. 7, 2011).