My dad practiced medicine for some 40 years as both a surgeon and family practitioner. He raised us to believe that someone who did not have objectively detectable causes for their physical symptoms was not really ill: it was “all in their head.” The medical term for that idea is “psychosomatic disorder.”
The Tax Code makes the same distinction. Section 104(a)(2) permits taxpayers to exclude damages recovered for objectively detectible physical injuries or physical sickness. But they may not exclude damages received for a sickness that is simply “all in their head.” The legal term for that idea is “emotional distress.”
Rebecca A. Tressler v. Commissioner, T.C. Summ. Op. 2021-33 (Sept. 13, 2021) (Judge Greaves), teaches us that damages even for severe emotional distress are not excludable unless properly linked to a physical injury. Ms. Tressler had sued her former employer, alleging a variety of wrongs. One allegation was that the employer failed to prevent a physical assault by another employee. Ms. Tressler claimed these wrongs had caused her emotional distress which, in turn, had caused various physical ailments. The employer settled. Both the IRS and Tax Court denied a §104(a)(2) exclusion because the settlement language failed to properly link the payments she received to physical injuries she sustained; they were just linked to her claim for emotional distress. It was all in her head.
It did not have to be this way. I think we can learn from this case how to write better settlement agreements.
Details below the fold.
Law: The Bruise Rule and §104(a)(2)
Section 104(a)(2) permits taxpayers to exclude from gross income “the amount of any damages ...received...on account of personal physical injuries or physical sickness.” The flush language of §104(a), however, provides an important caveat: “For purposes of paragraph (2) emotional distress shall not be treated as a physical injury or physical sickness.” Even so, the sentence after that still permits exclusion for “the amount paid for medical care...attributable to emotional distress.”
Damages received for emotional distress are, however, excludable if they are properly linked to a physical cause. Causality is crucial to establish the §104(a)(2) exclusion. A taxpayer must show “a direct causal link between the damages and the personal injuries or physical sickness sustained.” Lindsey v. Commissioner, 422 F.3d 684 (2005) (8th Cir. 2005). My dad would understand that.
Basically, you need a bruise. In cases of sexual assault, for example, the IRS has famously required some kind of physical injury “in the form of a cut, bruise, or other similar bodily harm” before damages for emotional distress would be excludable. PLR 20041022 (July 17, 2000).
The Tax Court has pretty much adopted this “bruise rule." For example, in Stadnyk v. Commissioner, T.C. Memo. 2008-289, the taxpayer sought to exclude emotional distress damages received for false imprisonment. She had been arrested, handcuffed, hand-searched, and made to strip in front of police officers. She argued that the physical restraint of an arrest was a requisite physical injury even though she admitted that nobody grabbed her, jerked her around, bruised her or hurt her. The Tax Court rejected the idea that physical restraint by itself was a physical injury. The injury was all in her head. Declared the Court: “Injury from false imprisonment is in large part a mental one where the plaintiff can recover for mental suffering and humiliation. The alleged false imprisonment...did not cause her to suffer physical injury as required for relief under section 104(a)(2).” My dad would understand that.
Notice how Ms. Stadnyk sought to exclude pure emotional distress damages that had no physical illness manifestation. But physical manifestations, such as TMJ, can result from psychosomatic disorder or, to use the legal term, emotional distress. That is not good enough! It is not enough that some physical sickness is lurking in the facts of the case. The damage award must link the recovery to the physical illness or injury. Allum v. Commissioner, T.C. Memo. 2005-177 ("The mere mention of 'personal physical injury' in a complaint does not, by itself, serve to exclude the recovery from gross income under section 104(a)(2).").
For example, in Goode v. Commissioner, T.C. Memo. 2006-48 (Mar. 21, 2006), the taxpayer sued his former employer—the District of Columbia government—for illegal retaliation. He excluded his settlement proceeds because, he argued, the amount was compensation for various debilitating physical ailments he developed as a direct result of public, repeated, vehement verbal assaults by the Deputy Mayor. The physical ailments included migraine headaches, stomachaches, and hand numbness. Judge Nims did not doubt that Mr. Goode had suffered physically. But it was all in his head: “the consequent physical reaction petitioner experienced as a result of that trauma...illustrates the fact that...petitioner's illness, although evidently grievous, [was] a physical manifestation of emotional distress [and] his symptoms exhibit the hallmarks of a stress-induced condition.” Goode, at p. 12. My dad would understand that.
Today’s case presents a more difficult set of facts because there was undoubtedly physical injury in the events underlying the taxpayer’s lawsuit and subsequent settlement. It was not enough for the taxpayer to be able to exclude a damage recovery. Let’s take a look.
Ms. Tressler started working for Amtrak in 1987 and rose through the ranks. Starting about 2006, however, she suffered a series of unfortunate events: a train passenger stalked her, unknown persons wrote disturbing graffiti in her workspaces, she injured her ankle, she was sexually assaulted by a fellow employee. Ms. Tressler starting receiving psychiatric care for these events, eventually being treated for Post Traumatic Stress Disorder after the sexual assault. Op. at 2.
By 2009, unhappy with how Amtrak had addressed these events, she sued in federal district court, alleging that Amtrak’s inadequate responses had created a hostile work environment for her and, further, that Amtrak had retaliated against her for submitting complaints. All of this had cause adverse employment actions, including a constructive discharge. The District Court eventually dismissed the suit, granting Amtrak Summary Judgment.
Thus, Ms. Tressler’s Complaint was a mix. Counts I through VI asserted claims about employment discrimination and retaliation. The bulk of the District Court’s opinion deals with those claims.
However, Count VII of Mr. Tressler’s Complaint asserted a claim under the Federal Employers’ Liability Act (FELA), 45 U.S.C §51 et seq. That statutes says railroads “shall be liable in damages to any person suffering injury while he is employed by such carrier in such commerce....” The last part of the District Court’s opinion deals with this claim.
The District Court sorted Ms. Tressler’s FELA claim into three distinct sets of physical damages: (1) back pain, headaches, and numbness in her hand resulting from being forced to change her seating position to avoid the harassing passenger; (2) continued pain to her ankle due to inadequate response by management; and (3) back pain, headaches, numbness, and other stress-related symptoms, like weight gain, attributed to a hostile work environment created or condoned by Amtrak, notably the sexual assault. See Tressler v. Amtrak, Civil Action No. 09-cv-2027 (D.D.C. 2012) at p. 25 (Unpublished Memorandum Opinion Granting Summary Judgment to Amtrak).
The district court dismissed the first two set of injuries as time-barred. It also dismissed the third claim, the one related to the sexual assault. But the court did not doubt the sexual assault had occurred. Nope. There was no doubt about that. The dismissal was because Ms. Tressler could not show any evidence that Amtrak had been negligent in regards to the sexual assault. The court noted that it was undisputed that Amtrak had promptly investigated the assault and had fired the guy who assaulted her.
Ms. Tressler appealed the District Court’s judgment. In 2014 she and Amtrak settled the matter for $82,500. The settlement document allocated $27,500 of that amount to “settlement of Ms. Tressler’s claims against Amtrak” and allocated $55,000 to “settlement of Ms. Tressler’s claim for emotional distress damages related to her allegations” in the lawsuit. Amtrak paid the $82,500 in 2014.
Ms. Tressler did not file a return for 2014. In 2019 the IRS prepared a Substitute For Return and included all $82,500. Ms. Tressler timely filed a Tax Court petition, finding representation through the Catholic University Low Income Taxpayer Clinic. She conceded that she could not exclude the $27,500 allocated to her claims against Amtrak but argued that she could exclude at least half, if not all, of the $55,000 allocated to emotional distress. The logic of the taxpayer's argument is not clear from the opinion.
But our lesson for today is not how to fix an error ex post; it is how the legal difference between emotional distress and physical injury requires careful attention to prevent the error in the first place.
Lesson: The Wrong Way To Write A Settlement Agreement
Judge Greaves found that “the text of the settlement agreement itself resolves this issue.” Section 2 of the agreement set out the payment terms. In section 2.1 the agreement allocated $27,500 of the proceeds as “settlement of Ms. Tressler’s claims against Amtrak.” Section 2.2 then said that all the rest represented “settlement of Ms. Tressler’s claim for emotional distress damages related to her allegations” in the lawsuit. Finally, Section 2.5 gave a general liability release, saying that both set of payments were “inclusive of all claims by Ms. Tressler for any alleged damages against Amtrk, including, but not limited to, any alleged claims for physical injuries, emotional distress, attorneys’ fee, and costs.”
Do you see the problem? Section 2.5 adopts the §104(a)(2) distinction between “physical injuries” and “emotional distress” by separately stating them and then Section 2.2. foolishly allocates the $55,000 of damages to only “emotional distress.”
Judge Greaves saw the problem. He notes that the Complaint itself repeatedly alleges that petitioner sustained emotional distress as well as physical injuries, thus separating the two types of injuries. The settlement agreement did not fix that problem. Writes Judge Greaves:
“We recognize that petitioner’s complaint in District Court included allegations of physical injuries, but section 2.5 does not state that any part of the $55,000 payment is attributable to the settlement of a physical claim. *** We simply cannot accept petitioner’s request to allocate the $55,000 payment among her claims for ‘physical injuries, emotional distress, attorneys’ fees, and costs’ when section 2.2 attributes the whole $55,000 to her claim for emotional distress damages....” Op. at 8.
The Court did allow Ms. Tressler to exclude her costs associated with her emotional distress, the psychiatric treatment, as permitted by the flush language in §104(a)(2). That amounted to about $7,000. But she had to include all the rest of the settlement in income.
Comment: Doing It Right
My students often erroneously believe that §104(a)(2)’s distinction between physical injuries and emotional distress means taxpayers can never exclude recovery of damages for emotional distress. Not true. The plain language in §104(a)(2) says that taxpayers can exclude any damages so long as they are received “on account of” physical injury or sickness. So damages for emotional distress can be excluded if the emotional distress is “on account of” a physical injury or illness.
Judge Greaves makes that point on p. 9 of the Opinion: “Section 2.2 of the settlement agreement allocates the $55,000 to petitioner’s emotional distress but does not say what caused her emotional distress.”
In this case, I think Ms. Tressler’s first lawyer missed an opportunity to help her by paying closer attention to the drafting of the settlement agreement. The lawyer was doubtless lulled into carelessness by the allegations of physical injury in the Complaint. But as Judge Greaves notes, the settlement agreement language does not properly link that up to the damages received. I think this case would come out differently if section 2.2 had provided that the $55,000 was being paid “in settlement of the emotional distress caused by the physical injuries sustained by Plaintiff in the course of her employment.” What do you think?
Even with my language, there would still be a question of causality. Notice that Ms. Tressler’s claims against Amtrak were not that Amtrak itself caused her physical injury; the claims were that Amtrak acted wrongfully in reaction to events, including those causing her physical injury, notably the sexual assault. I welcome comments on that idea.
Coda: My dad is now 91 and lives his life in 3-minute increments. Dementia has robbed him of knowing where he is, or even that he used to be a doctor. But the mind is a mystery: he still remembers all the words to songs such as “Accentuate The Positive” which he sings at least once a day while holding my mom’s hand. And, until his dementia interfered, he was still reading all the latest in medical science. So I am confident he would now no longer believe in the sharp distinction between "head" and "body" that is still reflected in the tax law. There is just too much new neurological research suggesting otherwise. Eventually, medical science will refute or at least narrow the concept of psychosomatic disorder. Eventually, tax law will follow and recognize that emotional distress is indeed a type of physical injury or illness.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law. He invites readers to return each week to TaxProf Blog for another Lesson From The Tax Court.