Tax Court Refutes PTSD Tax Claim

By Ken Berry.

If an individual receives an award or legal settlement attributable to a personal injury or illness, they normally don’t owe any federal income tax on the payment. However, the onus is on the individual to prove a direct cause. As shown in a new case involving a claim of post-traumatic stress disorder (PTSD), Estate of Finnegan, TC Memo 2024-42, 4/10/24, the supporting documentation can be critical.

Background: Most types of compensation—such as wages received for working at a job—are subject to federal income tax. However, amounts received as compensation for personal physical injuries or illnesses are generally exempt from tax. This includes legal judgments, awards or settlements resulting from personal injury lawsuits. Conversely, payments for for non-physical injuries—including discrimination, defamation and invasion of privacy—are taxable like other types of compensation, unless specifically exempted under the tax law.

In certain instances, a taxpayer will claim that an award or settlement is intended to compensate them for emotional distress or some other mental trauma like PTSD. As you might imagine, the IRS often disagrees with these assertions and the tax treatment is challenged in the courts. Any legally-binding documents may determine the outcome.

Facts of the new case: The state police of Indiana had investigated a couple for their conduct resulting in the tragic death of their daughter at age 14. Criminal charges were filed against the couple but later dismissed. Nevertheless, the state removed the couple’s other children from their home for an extended period during the investigation.

Eventually, the couple filed suit in state court, contesting the allegation of medical neglect of their deceased child. The court found in favor of the taxpayers. Then the entire immediate family—the parents and the siblings if the deceased child—sued the state of Indiana for various actions against them following the child’s death, including civil right violations.

The jury awarded the taxpayers compensatory damages totaling $31.5 million. Specific amounts were based on violations for each constitutional right. Ultimately, the case was settled out of court for $25 million.

Tax point of contention: The family claimed that the entire $25 million settlement should be excluded from federal income tax due to the PTSD they suffered as a result of the state’s actions. Reason: Damages that are attributable to physical injury or physical sickness are tax-exempt under the prevailing laws and regulations.

The Tax Court examined settlement agreement and pleadings to analyze the nature of the claims. It found no mention of PTSD and that this condition was only uttered one time during the couple’s testimony. The Court concluded that the taxpayers had not established sufficient grounds for proving their argument. Accordingly, the full settlement is taxable.

Practical approach: Before you sign any settlement agreement, have the document reviewed by a tax professional. A slight change may save valuable tax dollars.