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Tax Court: Tax Pain for Emotional Distress Damages

Oct 6th 2017
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If a client receives a settlement or other damages compensating him or her for a physical injury or illness, the payment is tax-free to the recipient. Conversely, an amount representing damages for emotional distress is taxable. As evidenced by a new case, Collins, TC Memo 2017-74, 9/11/17, it can be difficult to separate the two.

Under Section 104(a)(2) of the tax code, and its accompanying regulations, damages paid for personal physical injury or illness are specifically excluded from federal income tax. However, because emotional distress isn’t considered to be a “physical” injury or illness under the regulations, these amounts must be reported as taxable income. Not surprisingly, the issue of whether payments are attributable to emotional distress is frequently contested in the courts.

In the latest court finding, the taxpayer worked for Public Service Electric & Gas (PSE&G). After almost 40 years at PSE&G, he was transferred to an office in Audubon, New Jersey, and was subjected to a racially hostile work environment. In January 2011, the taxpayer’s doctor diagnosed him with depression, general anxiety, disorder, hypertension, blood clots, and muscle spasms. He left work on disability leave.

In May 2011, the taxpayer brought suit against PSE&G in New Jersey State Court, setting forth the following three counts:

  1. PSE&G had subjected him to a racially hostile work environment.
  2. PSE&G had discriminated against him on account of his race.
  3. PSE&G had retaliated against him on account of his complaints of discrimination.

In support of the first two counts, the taxpayer asserted, among other things, that his supervisor required him to perform work in a more burdensome manner than that of white individuals in comparable positions. For instance, the supervisor purportedly gave him more meter-reading stops on Saturdays than were given to white employees.

For each count, the taxpayer alleged that, as a result of PSE&G's action, he had "suffered severe emotional distress and anxiety, with physical manifestations, including high blood pressure.”

Also, as part of each count, he alleged that PSE&G's harassment and discrimination against him had caused him to begin taking anti-depressant medication and to be treated by both a therapist and psychiatrist.

Eventually, PS&G agreed to a term sheet specifying payments, totaling $275,000, for the following:

  • $90,000 payable to the taxpayer’s attorneys;
  • $15,000 to the taxpayer for reimbursement of his unpaid medical expenses;
  • $85,000 to the taxpayer for emotional distress; and
  • $85,000 to the taxpayer, less federal and state withholding taxes.

However, the taxpayer argued in court that the $85,000 for emotional distress was mischaracterized in the term sheet. He said it would have been more accurate if it was portrayed as being for "physical injury and physical sickness," including high blood pressure.

The IRS contended that the term sheet was explicit and accurate. Furthermore, there were no allegations in the complaint that the taxpayer suffered physical injuries or was seeking damages for physical injuries or sickness.

Although there may be some ambiguity as to what the parties intended the term “emotional distress” to encompass, the taxpayer failed to convince the Tax Court that the physical manifestations that he may have suffered, including high blood pressure, amounted to physical injuries or physical sickness within the meaning of section 104(a).

The fact that he suffered physical symptoms from emotional distress doesn’t mean that damages received on account of the emotional distress qualify for the tax exclusion. Thus, the $85,000 payment is fully taxable.

Moral of the story: When arranging a settlement for clients, have the reasons for payment clearly spelled out. It can support your client’s claim for the tax exclusion if amounts are said to be attributable to physical injury or illness, instead of emotional distress. 

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