The proper federal tax treatment for any given settlement payment is something of an enigma.  Generally, federal courts (and thus, the IRS) respect the terms of a settlement agreement if the terms are clear and the parties expressly allocate the settlement payment or payments to one or more of the underlying claims or causes of action at issue.  But, if one or more of these requirements are not present, federal courts are left searching through other evidence in an attempt to determine the payor’s intent, which, absent an express allocation, generally governs the tax characterization of the payment.

The terms of a settlement agreement may become significant in the context of settlement payments received in lieu of damages for personal physical injuries and/or physical sickness.  Under Section 104(a)(2) of the Code, these payments are not taxable.  However, Section 104(a) specifically provides that settlement payments received in lieu of damages for emotional distress are taxable.  So, what is the difference and how can a taxpayer ensure that any settlement payments received are properly treated as non-taxable under Section 104(a)(2)?

What is Emotional Distress?

Before diving into the case law of Section 104(a)(2), it is important to define what “emotional distress” means under the statute.  Significantly, Section 104(a) does not define the term “emotional distress.”  Neither do governing regulations.  Nevertheless, it is clear that the term is at least broad enough to encompass certain non-economic damage claims, such as mental anguish, depression, and anxiety.  Indeed, the legislative history of Section 104(a)(2) goes further—it indicates that the term “emotional distress” also includes physical symptoms, such as insomnia, headaches, and stomach disorders, provided these symptoms resulted from emotional distress.[i]

But, not all emotional distress damage payments are taxable.  More specifically, the legislative history of Section 104(a)(2) provides:

Because all damages received on account of physical injury or physical sickness are excludable from gross income, the exclusion from gross income applies to any damages received based on a claim of emotional distress that is attributable to a physical injury or physical sickness.[ii]

Accordingly, the legislative history makes an important distinction between payments received on account of emotional distress claims (which can include payments for physical symptoms resulting from the emotional distress) and payments received on account of physical injury or physical sickness claims (which can include payments for emotional distress due to such injury or sickness).

Domeny and Parkinson.

Given the unclear delineation between emotional distress damages and physical injury or physical sickness damages, it may not surprise you to learn that the United States Tax Court has had to wade into these waters to better explain the distinction between the terms.  For example, in Domeny,[iii] a taxpayer suffered from multiple sclerosis (MS), which caused her to experience a litany of physical ailments including numbness from the waist down, fatigue, lightheadedness, vertigo, and burning sensations behind her eyes.  Although these ailments were often times debilitating, the taxpayer nevertheless began employment with a nonprofit organization that was involved in public fundraising.

Unfortunately for the taxpayer, the nonprofit appointed a new executive director shortly after her employment began.  The executive director and the taxpayer had a strained working relationship from the beginning, which caused the taxpayer’s MS symptoms to flare up.  Moreover, the taxpayer’s MS symptoms were further exacerbated when she discovered that the executive director was embezzling funds from the nonprofit.  Eventually, the taxpayer visited her physician, who advised her not to return to work until after her symptoms improved.

With this news, the taxpayer informed the executive director that she would be taking a temporary leave of absence.  The executive director did not take the news well and terminated her from her position.  The termination caused the taxpayer’s MS symptoms to again grow worse, and she hired an attorney to represent her against the nonprofit for wrongful termination.

With the assistance of counsel, the taxpayer and the nonprofit entered into a settlement agreement in which the nonprofit agreed to pay the taxpayer $33,308.  In exchange, the taxpayer agreed to release all of her claims against the nonprofit.  The taxpayer and her attorney received three payments:  the first payment was for $8,187.50, which the taxpayer treated as wages on her tax return; the second payment was also for $8,187.50 and was paid directly to the taxpayer’s attorney; and the third payment of $16,933 was paid directly to the taxpayer with a Form 1099-MISC designating the payment as “Nonemployee compensation.”

The sole issue before the Tax Court was the proper tax characterization of the $16,933 payment to the taxpayer.  The taxpayer contended that the payment should be excluded under Section 104(a)(2) because she received the payment due to her physical injuries and/or physical sickness associated with MS.  Conversely, the IRS argued that the settlement payment was ambiguous—i.e., that the payor’s intent could not be determined and therefore the payment should be presumed to be taxable as ordinary income.

The Tax Court agreed with the IRS that the terms of the settlement agreement were ambiguous.  Accordingly, the Tax Court looked at other evidence in an attempt to determine why the nonprofit made the $16,933 payment.  Based on the separate payments and the information reporting of the nonprofit, the Tax Court concluded that an inference could be made that the payment at issue was due to the taxpayer’s physical injuries and/or physical sickness.  More specifically, the Tax Court concluded:

[P]etitioner has shown that her work environment exacerbated her existing physical illness.  Petitioner’s condition and her MS flareup caused by her working conditions was intense and long lasting.  Petitioner was physically unable to work until sometime in 2006, more than 1 year following her termination.  She has shown that the only reason for the $16,933 payment was to compensate her for her physical injuries.

Parkinson[iv]  too involved a fairly ambiguous settlement agreement, although not as ambiguous as the facts above in Domeny.  In Parkinson, the taxpayer worked as a chief supervisor in a medical center.  As part of his employment, he regularly worked long hours, often under stressful conditions.  During his shift one day, the taxpayer suffered a heart attack.  Although the taxpayer sought to continue his employment with the medical center, he also sought to reduce his average workweek from 70 hours to 40 hours.  Regrettably, the taxpayer suffered a second heart attack and stopped working altogether.

The taxpayer filed a lawsuit against the medical center and two of its employees.  In his complaint in federal district court, the taxpayer alleged that the medical center had violated the American with Disabilities Act of 1990 (ADA) by failing to accommodate his severe coronary artery disease.  He also asserted common law claims of intentional infliction of emotional distress and invasion of privacy by two employees who worked at the medical center.  His ADA claims were subsequently dismissed as untimely, resulting in the taxpayer filing a separate complaint in Maryland against the medical center and the two employees alleging the same common law claims that he had asserted in the federal suit.

The taxpayer and the medical center settled out of court.  Pursuant to the terms of the settlement agreement, the medical center agreed to pay the taxpayer $350,000 “as noneconomic damages and not as wages or other income.”  In 2005, the taxpayer received a $34,000 payment from the medical center and treated it as nontaxable under Section 104(a)(2).  The IRS examined the return and disagreed that the $34,000 payment fell under the exclusion of Section 104(a)(2).

On these facts, the Tax Court agreed with the IRS that the settlement agreement failed to expressly allocate or characterize the settlement payment other than to summarily state that it was made “as noneconomic damages and not wages or other income.”  However, to determine whether the settlement payment was taxable, the Tax Court turned to the legislative history of Section 104(a)(2).

In this regard, the Tax Court noted that “[w]ith respect to a claim for emotional distress . . . the legislative history distinguishes damages attributable to physical injury or physical sickness, which are excludable, from damages attributable to emotional distress or ‘symptoms’ thereof, which are not excludable.”  Regarding symptoms, the Tax Court noted that in medical literature a “symptom” is “subjective evidence of disease or of a patient’s condition, i.e., such evidence as perceived by the patient.”  Moreover, the Tax Court reasoned that the medical field distinguishes between a “symptom” and a “sign,” the latter of which is defined as “any objective evidence of a disease, i.e., such evidence as is perceptible to the examining physician, as opposed to the subjective sensations (symptoms) of the patient.”  Given the distinction between a symptom and a sign, the Tax Court reasoned:

It would seem self-evident that a heart attack and its physical aftereffects constitute physical injury or sickness rather than mere subjective sensations or symptoms of emotional distress.

*     *     *

Clearly . . . . petitioner’s State court complaint did reflect, extensively, his assertions of physical injury and sickness.  The complaint alleged that the actions of the medical center and its employees directly caused his second heart attack.  Further, the complaint alleged that petitioner’s complete disability and permanent damage to his cardiovascular system resulted directly from his heart attack.

On this basis, the Tax Court held that ½ of the $34,000 payment, or $17,000, should be excluded under Section 104(a)(2).

Conclusion. 

The facts in Domeny and Parkinson are common ones in this practitioner’s experience.  Indeed, in most cases, federal taxes are a mere afterthought because the taxpayer wants to end the litigation and receive the settlement payment as quickly as possible.  However, with the highest marginal income tax rates hovering at 37%, this may be a huge mistake.  As discussed above, federal courts and the IRS will generally respect allocations made in a settlement agreement, provided the terms of the agreement are clear regarding the allocation.  If the taxpayer’s attorney can have opposing counsel agree on an express allocation of the payment to Section 104(a)(2) damages and not emotional distress, the taxpayer can generally walk away with a better chance of more of a recovery.

In some cases, opposing counsel may flat-out refuse to agree on an allocation.  Here, it may be helpful for the taxpayer to engage a tax attorney to:  (1) better explain to opposing counsel why the allocation should be made in this manner; or (2) alternatively, to have the tax attorney tinker with the settlement agreement language to put the taxpayer in the best possible position for later contending on a tax return that the payments represent non-taxable Section 104(a)(2) damages and not taxable emotional distress damages.  Moreover, tax attorneys can work with opposing counsel in ensuring that proper information returns (e.g., Forms 1099, etc.) are either issued or not issued to avoid future headaches come tax reporting time.

[i] H. Conf. Rept. No. 104-737, at 301 (1996), 1996-3 C.B. 741, 1041.

[ii] Id. at 301, 1996-3 C.B. at 1041.

[iii] Domeny, 99 T.C.M. (CCH) 1047 (2010).

[iv] Parkinson, 99 T.C.M. (CCH) 1583 (2010).