Tax Court Rules Emotional Distress Damages are Taxable

Suppose one of your clients is awarded damages resulting from a job-related injury. The first tax question to ask is whether the damages resulted from a physical mishap or illness or if they are attributable to emotional distress. It can make a big difference, as one taxpayer found out – the hard way — in a new Tax Court case.

The controlling tax law provision in this area is Section 104(a)(2). Under this section, 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 prevailing regulations, these amounts must be included in taxable income. Some scientists or individuals in the medical profession may cringe, but that’s the law, at least for now.

It may be difficult to separate physical injuries from mental or emotional ones or the distinctions may appear arbitrary. That proved to be the undoing of the taxpayer in the new case.

Key facts: Ms. Barbato, a letter carrier with the U.S. Postal Service (USPS), sustained neck and back injuries in an automobile accident in 1991 while she was on the job. Because of physical limitations caused by this accident, Barbato was assigned to an inside USPS position where she didn’t have to carry mail. However, in 2004 a new station manager reassigned her to a mail route.

After Barbato returned to carrying mail, she began to experience more pain. The new manager, as well as other supervisors, purportedly scrutinized her work more closely than her co-workers, retaliating against Barbato because she requested medical accommodations, and creating an overall hostile work environment. As a result of these actions, Barbato suffered severe stress and emotional difficulties.

Barbato filed complaints against the USPS with the Equal Employment Opportunity Commission (EEOC). In 2011 an EEOC administrative judge determined that she was entitled to non-pecuniary damages of 70,000.

The EEOC judge stated that Barbato suffered from depression, anxiety, sleep problems and post-traumatic stress disorder due to the discriminatory actions of her supervisors. However, the judge stated that her physical pain was not caused by the USPS’ discrimination.

On her 2011 return, Barbato excluded the $70,000 in damages from taxable income and the IRS objected. It issued a notice of deficiency to Barbato and a substantial underpayment penalty. Now the Tax Court has sided with the IRS. Based on the EEOC judge’s ruling, the payment for the discriminatory actions was related to emotional distress, not physical injury, Therefore, the damages are taxable (Barbato, TC Memo 2016-23).

The EEOC ruling provided a blueprint in this case, but the distinction between physical injury and emotional distress isn’t always clear. Until the tax law catches up with science, taxpayers may continue to be flummoxed by these rules. Advise your clients that tax relief may be illusory.