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Rescued From the Brink of Insanity: How To Tell Whether Litigation Damages Are Taxable

You’ve just settled a long and arduous lawsuit with a hostile adversary who wouldn’t give an inch. As you are reclining back in your easy-chair and relishing the moment, it suddenly dawns on you, “Must I pay taxes on this award?”

This is an important question, yet one that is easy to overlook with the million other things to worry about when settling a case … at least until the tax bill arrives. As mind-numbing as the taxation of litigation damages might be, an ounce of prevention is worth a pound of cure.

Believe it or not, the rule for compensatory damages for physical injuries was never intended to be as indecipherable as the dead sea scrolls. Under Section 104 of the tax code, they are not taxable. But it’s not that simple. As with anything else, once the lawyers get involved, things get messy. And litigation damages are no exception.

Determining exactly what is meant by the term, “physical” is like trying to solve a riddle wrapped up in an enigma. Some of it comes down to wordplay. As a way of backing our way into this, let’s begin with the general rule. If you make a claim for emotional distress, your damages are taxable. If you accuse the defendant in a lawsuit of causing you harm, (i.e., of causing you to become physically sick), your damages are not taxable. Now that we established the baseline rule, we’re ready for a curve ball. If emotional distress causes you to be physically sick, then you can throw out the general rule with the bathwater because these damages are taxable. As you may have guessed, the order of events and how you label them is of significant interest to the IRS when it comes down to litigation damages and whether or not they are taxable.

If you are physically sick or physically injured, and your sickness or injury causes emotional distress, those emotional distress damages are unlikely to be taxable. While this wordplay may seem like nonsense, it is nonetheless important.

The “physical” requirement that is much to blame for the confusion comes from an obscure footnote in the legislative history to the tax code. It defines “emotional distress” as including physical symptoms, such as insomnia, headaches, and stomach disorders, which may result from such emotional distress. See H. Conf. Rept. 104-737, at 301 n. 56 (1996).

All compensatory damages stemming from a physical injury or physical sickness are not included in gross income. Even in employment cases, some plaintiffs can do an end-run around paying taxes. For example, in Domeny v. Commissioner, Ms. Domeny had multiple sclerosis (“MS”). Her MS worsened over time due to a stress-induced work environment, including an embezzling employer. Ultimately, her doctor declared that her too ill to work. On the heels of finding this out, her employer immediately fired her, further exacerbating her MS symptoms.

Mrs. Domeny settled her employment case out of court and did not include some of the money as gross income. The IRS disagreed, but Ms. Domeny did not give in, taking the IRS all the way to Tax Court where she scored a resounding victory. The court had no problem seeing the forest from the trees, holding that Mrs. Domeny’s health and physical condition clearly worsened as a result of how her employer treated her. As a result, the court held that a part of her settlement was not taxable.

In Parkinson v. Commissioner, a man suffered a near fatal heart attack while on the job. He had to reduce his hours, took medical leave, and eventually had to discontinue working altogether. He filed a lawsuit under the Americans with Disabilities Act (“ADA”). In it, he argued that his employer failed to make the necessary workplace accommodations that would have otherwise allowed him to continue to work despite suffering from coronary artery disease. He lost his ADA suit, but not his will to fight.

The employee then sued his employer in state court for intentional infliction of emotional distress and invasion of privacy. In his complaint, he alleged that the employer’s misconduct caused him to suffer a debilitating heart attack at work, making him unable to work. He settled and claimed that one payment was not taxable. The IRS disagreed. Unable to resolve the matter, he took the IRS to Tax Court. In his petition, the employee argued that the payment was for physical injuries and physical sickness caused by severe emotional distress. The IRS disagreed, downplaying the payment as nothing more than an emotional distress recovery that was taxable.

The Tax Court held that damages received on account of emotional distress that are caused by physical injury or physical sickness are excludable from gross income. The court distinguished between a “symptom,” on the one hand and a “sign” on the other. The court defined a symptom as “subjective evidence of disease of a patient’s condition.” Conversely, the court defined a “sign” is evidence perceptible to the examining physician. The Tax Court shot down the IRS’s argument that a person can never assert physical injury or physical sickness as the basis for a claim for emotional distress. The court reasoned that intentional infliction of emotional distress can cause a person bodily harm.

A major shortcoming about the settlement agreement in Parkinson is that it lacked sufficient detail about the nature of the payment and its tax treatment. Nor did it mention anything about tax reporting. There was barely even a scintilla of evidence that medical testimony linked Parkinson’s condition to his employer’s actions. Yet, Parkinson still prevailed. This has given rise to a rather vague and ambiguous rule that will only murky the already cloudy waters. Damages for physical symptoms of emotional distress (headaches, insomnia, and stomachaches) might be taxable.

What is certain, however, is that physical symptoms of emotional distress have a limit. For example, ulcers, shingles, aneurysms, and strokes may all be an outgrowth of stress. It seems unconventional to lump them all together as ‘mere symptoms of emotional distress,’ but that is exactly what the court did. Extreme emotional distress can cause a heart attack, which is not a symptom of emotional distress. The Tax Court in Parkinson agreed.

If you’re feeling as lost as Harry Potter was in the Triwizard Maze (a maze from “Harry Potter” that is populated by various obstacles and dangers that each Champion must overcome), help is on the way.

Medical records and settlement agreement language is your lifeline. These can help to sort things out as cleanly as the sorting hat in Harry Potter. With the right combination, you may be able to resolve an IRS examination favorably. For a payment to be tax-free on account of physical sickness, the taxpayer must present evidence that he made a claim. He need not prove that the defendant actually caused the sickness. But he at least must show that he claimed it. In addition, he must show that the defendant knew about the claim, and at least considered it in making payment.

To prove physical sickness, the taxpayer must seek and undergo medical treatment and submit proof of such treatment in the form of medical bills, hospital records, doctor’s reports. He must also produce evidence that he actually claimed the defendant caused or worsened his condition. This is one of many issues in the Taxation of Damage Awards and Settlement Payments.

The more medical evidence the better. If there is little more than a breadcrumb of evidence of medical expenses in the litigation, your strategy might be to settle the case outside of court instead of going to court with a weak case. A declaration from the plaintiff is not only beneficial but essential. A declaration from a treating physician or an expert physician is appropriate, as is one from the plaintiff’s attorney. Be proactive and have the documents that you will need for trial complete and ready for submission at the time of settlement or, at the latest, at tax return time. Do as much as humanly possible in advance and do not procrastinate. Documents that you gather up later may be too little too late.

Finally, there is the settlement agreement. Settlement agreements should explicitly state whether the damages are taxable or not taxable. Just like generality is the enemy of art, so too is generality the enemy of tax avoidance.

Just like something as innocuous as a furtive glance is likely to be viewed by a police officer as suspicious during a traffic stop, the IRS is likely to view everything as income unless you can prove otherwise. Try to be as thorough as possible when it comes to referencing tax forms in the settlement agreement too. While this might all seem like a hassle, a careful consideration of the alternative will disabuse you of this notion: the untimely arrival of IRS Forms W-2 and 1099 in your mailbox a year after the settlement.

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