Generally, under the Internal Revenue Code, amounts received in settlement or as a result of litigation for damages (other than punitive damages) received on account of personal physical injuries or physical sickness are not included in “gross income” for tax purposes. A recent case in the United States Tax Court sets forth the limitations of this exclusion on awards and payments for emotional versus physical afflictions.
In that Tax Court decision (Debra R. T. Barbato, TC Memo 2016-23), the taxpayer, a letter carrier for the U.S. Postal Service (USPS), sustained injuries after a car accident while on the job. Due to her physical limitations, the taxpayer accepted a new USPS position allowing her to work at the postal station. Years later, when she was reassigned to carry mail again, she began to have more pain. Her manager did not respect her requests for medical accommodations, making the taxpayer’s work life difficult and causing her to experience emotional difficulties.
After filing a complaint against the USPS with the Equal Employment Opportunity Commission, the taxpayer was awarded $70,000 for the emotional distress. She did not include this amount as income on her tax return. Upon examination, the Internal Revenue Service found the award to be taxable for income tax purpose, and the matter moved to the Tax Court.
The Tax Court agreed with the Internal Revenue Service that the damages were taxable. Because they were awarded for emotional distress caused by discrimination, the Section 104(a)(2) exclusion for personal physical injury or physical sickness did not apply. The taxpayer was required to include the amount in her gross income.
Taxation of legal settlements is always a complex matter, and tax implications should be understood and incorporated into settlement discussions during the course of the matter – not after the fact. Oftentimes, language in the settlement agreement can shade the receipt of the award to ensure that all tax benefits to which the recipient is entitled under the law are properly used. Failure to do so can often lead to later misunderstandings and unexpected outcomes.