Settlement payment for depression not excludable from gross income

Tax planners frequently struggle with litigation settlement payments in an effort to categorize them as non-taxable.  The rules on taxability of these payments has evolved over the years; generally making it harder to keep these payments exempt from tax.  A U.S. Tax Court case reported this month clarifies some of these rules.

Background. Under Internal Revenue Code Sec. 104(a)(2), non-punitive damages received by a taxpayer in a suit or by agreement (whether in a lump-sum or as periodic payments) as compensation "on account of" personal physical sickness or physical injury are excluded from a taxpayer's income.   These payments are generally deductible by the payer if paid as part of the payer's business. injury or personal

The Small Business Job Protection Act of 1996 ("SBJPA") amended Code Sec. 104(a)(2) to provide that (1) punitive damages do not qualify for the income exclusion and (2) the income exclusion generally is limited to amounts received on account of personal "physical" injuries or "physical" sickness. SBJPA further amended Code Sec. 104(a) to provide that, for purposes of Code Sec. 104(a)(2), even though emotional distress is not considered a physical injury or a physical sickness, damages for the amount paid for "medical care" (described in Code Sec. 213(d)(1)(A) or Code Sec. 213(d)(1)(B)) for emotional distress are excluded from income. SBJPA's legislative history indicated that the term "emotional distress" includes physical symptoms (e.g., insomnia, headaches, stomach disorders) which may result from the emotional distress. (H Rept No. 104-586 (PL 104-188) p. 144).  In September of 2009, the U.S. Treasury issued proposed regulations reflecting these statutory amendments. 

Tax Court Case. Wells, TC Memo 2010-5 dealt with one aspect of Code Section 104(a).  Marion Wells filed suit against her employer, the Colorado Department of Transportation (CDOT), her supervisor, and her supervisor's superior alleging gender discrimination and retaliation under 42 U.S.C. §§ 1983 and 1988 and title VII of the Civil Rights Act of 1964, as amended, P.L. 88-352, tit. VII, 78 Stat. 253, codified at 42 U.S.C. secs. 2000e-2-2000e-17 (2006). She alleged gender-based employment discrimination and that stress due to altercations with her supervisor and the perceived inaction by CDOT resulted in her seeking therapy, taking extended leave, and eventually being terminated. The parties resolved all their claims in a settlement agreement under which Wells received $175,000 "as damages for her emotional distress due to depression and other claims, not as wages or back pay." She treated the settlement as excludable and didn't report the payment on her return.

On audit, IRS treated the payment as includable in Ms. Wells' gross income and determined a deficiency of $48,003.

The Tax Court concluded that the settlement payment was made as damages for emotional distress due to depression and that, as a matter of law, the damages were not excludable from Wells' gross income under Code Sec. 104(a)(2) , except to the extent of any amounts she expended for medical care to treat her emotional distress. The settlement wasn't attributable to physical injury or sickness, but to a nonphysical injury (namely, her claims of suffering gender-based discrimination and unlawful retaliation with respect to her employment)

The Court rejected her claim that since depression wasn't specifically excluded as a physical injury under Code Sec. 104, it was within the definition of a physical injury. The Court noted that this wasn't the correct standard for qualifying for an exclusion from income; a taxpayer must show that she falls within the clear scope of any statutory exclusion to qualify. The Court also noted that Wells didn't argue that the characterization of the payment didn't accurately reflect the nature of the claim or the settlement payment. Rather, she argued that she had been advised that the characterization would result in the payment not being includable in income. The Court said that a taxpayer's mistake of law does not excuse liability.

Attorney's Fees.  Taxpayers who pay attorney's fees out of a settlement or judgment can also run into problems.  The fees are usually "miscellaneous itemized deductions" which can only be deducted to the extent they exceed 2% of the taxpayer's adjusted gross income.  Also, they are non-deductible if the taxpayer is in the alternative minimum tax.

What to Do.  The best result for a plaintiff settling a case will be to characterize at least some of the settlement as compensation for a physical injury or sickness.  Thus, it will be important to document the taxpayer's physical condition and for settlement documents to reflect the language of Code Section 104(a).  This ruling illustrates that even a widely recognized medical condition (like depression) won't qualify if it is not a physical sickness.  This is the case even if a non physical condition (like depression) leads to physical symptoms.