Paul L. Caron

Monday, September 18, 2017

An Emotionally Distressing Lesson From The Tax Court

Last week, in the Summary Opinion of Collins v. Commissioner, the Tax Court agreed with the Service that a taxpayer could not exclude $85,000 under section 104(a)(2) for payments received for "emotional distress" even though that distress resulted in physical sickness.  It's a case that not only teaches an important basic lesson about 104(a)(2) but also exposes a distressing gap in current tax law.  More below the fold. 

Mr. Collins had sued his employer for workplace discrimination and retaliation.  One of his allegations was that he had "suffered severe emotional distress and anxiety, with physical manifestations, including high blood pressure."  The case settled, with $85,000 of the settlement was allocated to "emotional distress."  Could Mr. Collins exclude that $85k under section 104(a)(2)?  Mr. Collins---like many of my basic tax students---thought he could because he had undeniably physical sickness stemming from the stress of his workplace situation.  The Service and Tax Court properly said "no exclusion" based on current law.  

The basic lesson is all about causality.  Section 104(a)(2) excludes from gross income damages paid because of physical injury or sickness.  But the penultimate sentence in the flush language of 102(a) says that emotional distress alone does not count as physical injury or sickness.  So damages paid because of emotional distress are not excludable.  The House Conference Report that created this language said that they "intended that the term emotional distress includes symptoms (e.g., insomnia, headaches, stomach disorders) which may result from such emotional distress." H.R. Conf. Rept. No. 104-737, at 301 n.56 (1996).  However, Treasury Regulation 1.104-1(c)(2) provides that emotional distress damages "attributable to a physical injury or physical sickness" are excluded from gross income.  So if your emotional distress is because of a physical injury, payments for that are excludable.  But if the physical injury results from emotional distress, payments for that are not excludable.  An infamous example of how this causality works is the "bruise ruling" the IRS issued in 2002 where it said that if a taxpayer experienced emotional distress from sexual harassment, the excludable or non-excludable nature of resulting damages would turn on whether there was any evidence of physical harm, such as bruising. 

The result in Collins is distressing for many because current law is  based on an outdated dichotomy between "physical" and "emotional."  The gap in the tax law is this "emotional/physical" dichotomy.  Ronald Jensen (Pace) wrote a really good article critiquing the distinction as being contrary both to good science and good tax policy.  "When are Damages Tax Free: The Elusive Meaning of “Physical Injury” 10 Pitt. Tax Rev. 87 (2013).   Worth reading.

Bryan Camp, New Cases, Tax | Permalink


Hi Watson, yes, yes it should. I fixed most of the typos but missed that one. 102 is the exclusion for gifts, as you know. There IS no flush language in 102(a)!

Posted by: Bryan Camp | Sep 19, 2017 12:33:33 PM

Professor Camp, should the third sentence of the third paragraph refer to Code §104(a) instead of §102(a)? Great article.

Posted by: Watson Bowen | Sep 19, 2017 12:22:24 PM

@Sid: probably not the best advice. Taxpayer tried your strategy in Goode v. CIR, TC Memo 2006-48. (taxpayer asked employer not to file information return) and in Burditt v. CIR, TC Memo 1999-117 (taxpayer told his lawyer to make sure the settlement document contained "the proper personal injury language.”). Both taxpayers got hit with penalties. Your suggestion would expose the employer to penalties for not filing an information return and to potential criminal prosecution. See sections 6674, 6721, and 7203. Your suggestion would expose the taxpayer to sanctions, including both civil penalties and criminal prosecution, for fraud. See sections 6663, 7201, and 7206. And you! You would be exposed to both civil penalties and potential criminal prosecution---see sections 6694, 7206. You would also likely face professional sanctions. See Circular 230 (31 CFR, Subtitle A, Part 10), sections 10.21, 10.33, 10.34, 10.35, 10.50, and 10.51. Just saying...

Posted by: Bryan Camp | Sep 19, 2017 11:37:33 AM

Good catch Len, thanks! I've corrected the article so that It properly references 104(a)(2) all the way through (well, almost, I see one place I overlooked). I goof it up in class sometimes too, much to my own distress (not to mention the students' confusion).

Posted by: Bryan Camp | Sep 19, 2017 11:11:39 AM

1- Article should be referencing IRC SECTION 104, not 102.
2- Sid, were you Al Capone's accountant?

Posted by: len fuld | Sep 19, 2017 7:30:44 AM

Looks to me that the attorney screwed up...I would have insisted that the amount for emotional distress not be reported. the employer had nothing to lose and the employee a free ride. Therefore the IRS would have never known. This is the exact reason to have a tax attorney involved in litigation settlements....

Posted by: sid | Sep 18, 2017 5:13:00 PM

@Bruce: Does what it cost each taxpayer to acquire the $1 million matter to the "ability to pay" idea? Assume: it cost A $300k (attorney fees); it cost B $1 (the lottery ticket); and it cost C $500 (materials). Does that affect whether each has the same ability to pay? Note I am not counting either labor or lost labor as a cost.

Posted by: Bryan Camp | Sep 18, 2017 1:22:13 PM

Prior to the enactment of the "physical" injury limitation, it was not uncommon for departing executives to enter into a "settlement" of discrimination and intentional infliction claims against their employers and thereby receive what amounted to tax-free severance pay. In my view all personal injury awards should be taxable, even for physical injury. Consider three taxpayers, A, B, and C. A loses a leg in an accident and recovers $1M. B loses a leg in an accident, but is unable to recover any damages. B does, however, win $1M in the lottery. C was born with a missing leg and manages to sell one of her paintings for $1M. It would seem that all three have the same ability to pay and should pay the same tax.

Posted by: Bruce Wolk | Sep 18, 2017 10:32:23 AM

There is no indication that the physical sickness caused by the emotional distressed resulted in any out of pocket costs that would have been reimbursed by the award. As for the taxable part, the petitioner's job description could be changed to "Emotional Punching Bag" and the reward was taxable compensation for "Services Rendered."

Posted by: Michael S Cash | Sep 18, 2017 8:38:17 AM

I agree with the decision. Could you imagine the "line at the pay window" if they allowed the exclusion?

Posted by: BRIAN MCNAMARA | Sep 18, 2017 6:42:39 AM