No Tax Exclusion for Emotional Distress in Injury

A new Tax Court case, Tressler, TC Summary Opinion 2021-33, 9/13/21, shows that the way the settlement is worded can have a significant impact on taxability.

Under Section 104(a)(2) of the tax code, and 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 included in taxable income. Not surprisingly, the issue of whether payments are attributable to emotional distress or not is frequently contested in the courts.

Facts of the new case: The taxpayer, a resident of Virginia, was employed by a nationally known railway company as an engineer and road foreperson. Since 1987, she has asserted a litany of claims focused on workplace harassment and retaliatory employment practices.

Among other claims, the taxpayer alleged that she has endured emotional distress and experienced a workplace sexual assault, physical injuries resulting from a workplace stalking incident, physical manifestations of stress caused by the hostile work environment and an injury to her ankle sustained exiting a train while on duty. Eventually, she agreed to an $82,500 settlement with the railway company, including, but not limited to, amounts attributable to “any alleged claims for physical injuries, emotional distress, attorneys’ fees and costs.”

The taxpayer was treated for post-traumatic stress disorder (PTSD) arising from the workplace sexual assault and her other traumatic work experiences. She incurred out-of-pocket psychotherapy costs of $6,980. After initially failing to file a return for 2014, the taxpayer asserts that half of the settlement received that year should be exempted from tax under the Section 104(a)(2) exclusion.

Unfortunately, the Tax Court didn’t agree, based on the language of the settlement agreement. Reason: The main part of the payment was attributable to emotional distress, not physical injury. However, the Tax Court did allow a tax exclusion for the $6,980 paid for psychotherapy as medical care.

In this particular case, the emotional distress experienced by the taxpayer was related to physical injuries caused by the alleged behavior. If the agreement had clearly spelled out this connection, the taxpayer likely would have prevailed in court.

Lesson to be learned: Don’t rely on legal boilerplate in settlement agreements. When possible, make sure that a client’s claims are represented in a way that provides a tax exemption due to personal injury. Just a few sentences may suffice.