From the Archives: Taxation of Emotional Distress Payments

PROGRAMMING NOTE: During the holiday weeks, I’ll be re-posting popular blog posts from the past. New material will resume on Monday, January 4th.

This post from August of 2011 remains popular more than 4 years later.

Taxation of legal settlements relating to emotional distress can be tricky. In general, the settlement money is taxable … but there’s an exception in the case of physical damages caused by the emotional distress.

This blog post is about a Tax Court case where a taxpayer lost their case and had to pay taxes on a settlement for emotional distress.

—–

Originally published August 4, 2011

Amounts paid to a person for emotional distress are considered taxable income, as a taxpayer learned in Tax Court today (Thursday).  The taxpayer, a Julie McGowen, suffered emotional distress at a job she was working at in California.  As the Tax Court ruling explains, one of Ms. McGowen’s co-workers was apparently not pleasant to work with:

From August to December 2004 Mrs. McGowen was harassed at work by (a male coworker).  (The coworker) created an intimidating, hostile, and offensive work environment and, on one occasion, threw a binder at Mrs. McGowen.  Mrs. McGowen reported these incidents to her superiors, but her superiors did not take action to prevent (the coworker) from continuing to harass Mrs. McGowen.  Mrs. McGowen’s work conditions became intolerable and she began to develop symptoms of emotional distress (e.g., shaking, sweating, anxiety, sleeplessness, panic attacks, depression, etc.).  On December 19, 2004, Mrs. McGowen elected to take a medical leave of absence due to stress.

In March of 2005, Mrs. McGowen requested an extension of her leave of absence.  A few weeks later, the company fired her.  McGowen sued, and a $125,000 settlement was eventually reached.  Part of that settlement included $42,625 “for physical injury caused by emotional distress.”  When McGowen and her husband filed their tax return, they included other amounts from the settlement but did not include the payment for emotional distress.  Naturally, this caught the eye of the IRS.  The McGowens fought the IRS all the way to Tax Court.

The Tax Court sided with the IRS.  Lawsuit or settlement payments on account of “personal physical injury or physical sickness” are not taxable.  But the Internal Revenue Code specifically says emotional distress is NOT a physical injury or sickness.  From the Court ruling

Section 104(a)(2) … provides that emotional distress shall not be treated as a physical injury or physical sickness, except to the extent that damages attributable to emotional distress were used to pay for medical care….  Mrs. McGowen contends that the emotional distress payment constitutes damages received on account of physical injuries and is excludable pursuant to section 104(a)(2). We disagree.  There is no evidence that the binder physically injured Mrs. McGowen or that Mrs. McGowen suffered other than the symptoms of emotional distress.  Moreover, pursuant to the settlement agreement, Mrs. McGowen received damages on account of her emotional distress and not as a result of “a physical injury or physical sickness….”

After today’s ruling, Mrs. McGowen will now owe nearly $15,000 in additional taxes and penalties.  You can find the entire Court ruling here.