INCOME TAXATION OF EMOTIONAL DISTRESS CLAIMS

by Thomas D. Begley, Jr., Esquire, CELA

Questions frequently arise with respect to the taxation of emotional distress claims.  As a general rule, damages for emotional distress are subject to income tax.  However, a careful analysis can result in the elimination of this tax.  

Emotional Distress

            Emotional distress has been defined as a highly unpleasant emotional reaction (as anguish, humiliation, or fury) that results from another’s conduct and for which damages may be sought.  At one time, damages for emotional distress required proof of a physical injury; however, this is no longer necessary.  It is now recognized that individuals have a right to damages for emotional distress without physical injury or contact.  Sexual harassment, libel and slander cases may involve emotional distress as the main, or only, harmful result.  Bystanders to a physical injury must show physical closeness to the traumatic event and a relationship to the injured party.  Expert testimony from a psychiatrist or a therapist may be required to prove the existence of the distress and to place a dollar value on it.

Emotional Distress Symptoms

There is a difference between signs of emotional distress and symptoms of emotional distress.  Emotional distress may involve physical symptoms such as headaches, stomach disorders, and insomnia, but these are generally held not to be physical injuries or physical sickness.  Claims for intention infliction of emotional distress are taxable.  In addition, under the new tax law attorneys’ fees for an emotional distress claim are no longer deductible by the plaintiff.  Assuming a plaintiff received $200,000 for an emotional distress claim and the attorney’s fee was 40% the plaintiff would net $120,000 minus any costs or liens, but would have to pay income tax on the entire $200,000.  In a pre- or post-judgment interest would also be taxable to the plaintiff.  Punitive damages are always taxable.

Physical Injury/Physical Sickness

Unfortunately, it is not always clear whether an injury is a physical injury is a physical injury or physical sickness.  The IRS analysis of the law concludes:  (1) damages received from unwanted physical contact without observable bodily harm are not “on account of” personal physical injuries or physical sickness, and (2) physical injury can be determined from “observable bodily harms”, which can be monitored, such as bruises, cuts, swelling, and bleeding. To prove a physical injury or sickness, it is often helpful to produce evidence of medical care and evidence that the defendant actually caused or exacerbated the condition.  

Generally, damages for physical injury or sickness are not subject to income tax.  

Origin of the Claim

The taxation of a personal injury recovery depends on the origin of the claim.  Was the claim for emotional distress, for a physical injury, for a physical injury that led to emotional distress, or for emotional distress that led to a physical injury?  Compensation for a physical injury is tax free.  Compensation for emotional distress is generally taxable.  However, if there is a physical injury that led to emotional distress and the physical injury was the origin of the claim, then both the physical injury and emotional stress claim should be tax free.

Conversely, if the emotional distress arose from an employment claim, the employment claim would be taxable because such claims generally involve loss of wages and severance rather than physical injury or sickness so the origin of the claim would be taxable and the emotional distress flowing from the claim would also be taxable.  Generally, the defendant employer will issue a Form 1099 on which the IRS will be copied and this makes it much more difficult to allocate all or part of the recovery to a physical injury/physical sickness claim.

Allocation of Damages

In some cases it may be appropriate to allocate damages between various causes of action.  The allocation could be memorialized in the settlement agreement.  Settlement agreements are not binding on the IRS, but they do warrant attention.  One payment may be allocable to physical injuries or physical sickness and, therefore, be non-taxable while other damages may be allocated to the emotional distress, which would be taxable.  In these cases, evidence of medical care, a declaration from the treating physician or an expert physician, as well as a declaration from the plaintiff’s attorney, may be helpful.

If the origin of the claim is physical injury or sickness that leads to emotional distress and this can be verified medically, then the entire settlement should be income tax free.  However, if the client has taken a medical deduction in the past and those monies are recovered as a part of the settlement, then that portion of the settlement is taxable income.

The IRS looks at (1) the pleadings, (2) the negotiations, and (3) the actual settlement document (or jury verdict) to see what part, if any, of the damage award or settlement payment is received on account of personal physical injury or sickness.