Monday, September 18, 2017
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The result in Collins is distressing for many because current law is based on an outdated dichotomy between "physical" and "emotional."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.