Generally speaking, damages received by a taxpayer who suffered physical injuries or sickness is excludable under the Internal Revenue Code, meaning that the taxpayer does not have to include any such payments as income on his income tax return.
When money is received by a taxpayer pursuant to a settlement agreement, the nature of the claim underlying the settlement agreement controls whether that payment is excludable. If the settlement agreement is silent or not clear, then the taxpayer may have to prove to the IRS that the payment was for physical injuries or sickness.
In a recent case before the United States Tax Court, the taxpayer was subjected to a racially hostile work environment. He was subsequently diagnosed with depression, general anxiety disorder, hypertension, blood clots and muscle spasms. As a result of these maladies, the taxpayer left work on disability leave.
He subsequently sued his employer, alleging a racially hostile work environment, racial discrimination and employer retaliation. The lawsuit did not demand any compensation for any physical injury or physical sickness. The lawsuit was subsequently settled, and the taxpayer received $85,000 for emotional distress along with other payments.
Although the taxpayer reported the $85,000 payment on his tax return, he claimed a deduction in the same amount, apparently contending that the money he received for emotional distress was excludable from income. The taxpayer argued that there were physical manifestations of his emotional distress which gave rise to physical injuries and physical sickness.
The Tax Court held that if the taxpayer suffers physical symptoms from emotional distress, the money he receives in the settlement does not qualify for exclusion from gross income. As a result, the Tax Court held in favor of the IRS and stated that the payment in the amount of $85,000 was includible in income on the taxpayer’s tax return.
Have you received a payment for emotional distress or physical injuries? Has the IRS questioned whether that payment is includible as income on your tax return? Contact us, we can help. Call us before the IRS calls you!®