Claiming Emotional Distress:  
a Taxing Dilemma
  
January 19, 2016- Although the question of whether or not emotional distress claims are fully, partially or non-taxable when resolving personal injury lawsuits has pretty much been (or should have been) settled since 1996, many claims professionals, attorneys, mediators, financial advisers and even tax professionals continue to struggle with fully understanding the law. For good reason.

It's complicated!


Not really so much anymore. But it's easy to understand why there's still ample confusion on the topic. After all, physical injury claims are generally tax-free while non-physical injury claims are generally taxable.

That's the easy part.

Why then can't emotional distress, which certainly manifests the same symptoms regardless of claim origin, be as straightforward and receive consistent tax treatment?

Taxable Income

It's instructive to start with ratification of the Sixteenth Amendment in 1913 which gave Congress "the power to lay and collect taxes on incomes..."

More than 100 years and, according to the non-partisan Tax Foundation, over 70,000 pages later, we have the Internal Revenue Code (IRC) which tells taxpayers what is and is not taxable.

The U.S. Government Publishing Office (GPO) serves as the public's go-to resource for the Federal Government's official information repository including laws important to this dialog, to wit:

26 USC Sec. 61(a) - Says ALL INCOME is taxable unless it's excluded.

26 USC Sec. 104(a)(2) - Says all PERSONAL PHYSICAL INJURY claims (except for punitive damages) qualify for the income tax exemption referenced in 61(a) above.

NOTE: 104(a)(2) forms the foundation of the modern structured settlements industry.

That word "PHYSICAL" has been key since passage of the Small Business Job Protection Act of 1996 (Public Law 104-188) when it was coupled with 104(a)(2).

Prior to PHYSICAL's insertion into 104(a)(2), ambiguity prevailed leaving tax treatment to the creativity of the taxpayer, the seeming whim of the IRS and, in many cases, the courts.

So adding the word "physical" simplified things, right?

Unintended Consequences

Not so fast.  
 
Because Sec. 1605(b) (p. 84 of P.L. 104-188) specifically stated "emotional distress shall not be treated as a physical injury or physical sickness," many people assume this definition applies to emotional distress claims stemming from a personal, physical injury.

It does not.

(Note: Direct medical expenses to treat emotional distress, if not previously deducted or resulting in a tax benefit, are excludable if the settlement is otherwise taxable)  

Many employment cases circulating in those and the ensuing years (United States v. Burke, Commissioner v. Schleier and Murphy v. IRS chief among them), prompted Congress to take this aggressive position on emotional distress to ensure that employment and related torts were henceforth irrefutably taxable.

Still confused? You're not alone.

The Chicken and the Egg

Ultimately, whether or not emotional distress results in a taxable event depends on the origin of the claim and whether or not the recipient already received a tax benefit.

In other words, which came first: the physical injury
or the emotional distress?

If a physical injury (auto accident, slip and fall, dog bite, medical malpractice, etc.) causes emotional distress (with or without observable physical symptoms), income received from the settlement (except punitive damages) is fully tax-free.

If a non-physical injury (wrongful termination, contractual disputes, civil rights violations, etc.) causes the same emotional distress (with or without observable physical symptoms), income received from the settlement (except medical expenses not previously deducted) is fully taxable.

This would all be much more straightforward if a definition for the word PHYSICAL existed in the Code. Alas, no such luck.

One final head scratcher: Allocations are sometimes needed when claims or lawsuits contain elements of both types of damages such as occurred in Amos v. Commissioner aka the "Dennis Rodman" case.
 
Helpful Resources

If all this stuff still makes you dizzy, don't despair. There are a few places you can turn to for help on the issue:

The Department of the Treasury provides helpful guidance in the form of Publication 4345 which will aid in your navigation of the issue.

Call us! We're experts in this area and can help you through the rough patches. 
 
PRACTICE POINTER: Both physical and non-physical injury damages warrant structured settlement consideration.

Hoping this helps, we look forward to assisting you anytime you require professional expertise and guidance on this important topic.

Thank you for the opportunity to be of service and best wishes in the coming year for continued success in your personal and professional lives.

The Best, 

Dan Finn, CPCU, MSSC, RICP®
Master Structured Settlement Consultant™
Retirement Income Certified Professional®  
Dan@FinnFinancialGroup.com






 


NOTE:  This newsletter is presented for educational purposes only using material freely available in the public domain and should not be construed as tax or legal advice. All rights reserved.
 
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