From August to December 2004 Mrs.McGowen was harassed at work by Kevin Bulrice. (ed. note: that’s not Bulrice to the left, that’s Tom Brady on SNL) Mr. Bulrice created an intimidating, hostile, and offensive work environment and, on one occasion, threw a binder at. McGowen. McGowen reported these incidents to her superiors, but her superiors did not take action to prevent Mr. Bulrice from continuing to harass McGowen. McGowen’s work conditions became intolerable and she began to develop symptoms of emotional distress (e.g., shaking, sweating, anxiety, sleeplessness, panic attacks, depression, etc.).
McGowen was terminated and eventually sued her employers, alleging sexual harassment, failure to prevent sexual harassment, disability discrimination, failure to prevent discrimination, intentional infliction of emotional distress, and other causes of action. McGowen requested “compensatory damages for emotional distress and other economic and non-economic losses”.
McGowen and her employer settled out of court. The settlement agreement provided that her employer would pay McGowen’s attorneys $39,750, and pay McGowen $42,625 for lost income and $42,625 “for physical injury caused by emotional distress.”
On her 2007 tax return, McGowen reported the lost income payment as taxable income, but excluded the amount paid on account of emotional distress. The IRS disagreed, claiming the payment was not made on account of physical injury.
The Law: Section 104(a)(2) provides that gross income does not include the “amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness”. Section 104(a)(2) further provides that emotional distress shall not be treated as a physical injury or physical sickness, except to the extent that damages attributable to the emotional distress were used to pay for medical care, as described in section 213(d)(1)(A) or (B).
The Tax Court: The court sided with the IRS, explaining:
There is no evidence that the binder physically injured Mrs. McGowen or that Mrs. McGowen suffered other than the symptoms of emotional distress. Moreover, pursuant to the settlement agreement, Mrs. McGowen received damages on account of her emotional distress and not as a result of “a physical injury or physical sickness” as defined in section 104(a)
The Lesson: The best way to look at Section 104 is to consider the order of events: if a taxpayer suffers physical harm and as a result of the harm, also suffers emotional distress, all of the payments (other than punitive damages) should be excludable under Section 104. To the contrary, if the taxpayer suffers the emotional distress first, even compensation for physical symptoms that arise out of the emotional distress, such as insomnia, headaches, or stomach disorders, are not excludable. Obviously, those lines can grow blurry as the “symptoms” arising out of the emotional distress become more severe, for example, the development of an eating disorder. In these situations, a careful facts and circumstances analysis is called for prior to making the determination what amount, if any, of settlement or judgment proceeds are excludable from income.