Section 104(a)(2) of the Internal Revenue Code provides an exclusion from gross income for damages received for physical personal injury or physical sickness. The statute further provides that emotional distress is not a physical injury or physical sickness (although damages to pay for medical care attributable to emotional distress are excludable). However, the regulations under §104 state that damages for emotional distress attributable to a physical injury or physical sickness are excluded from income under section 104(a)(2).
In a recent case, the Tax Court held that, under the following circumstances, damages attributable to emotional distress rather than physical injury or sickness and, therefore, not excluded from income by §104(a)(2).
B was employed by the U.S. Postal Service as a letter carrier. In 1991 she sustained back and neck injuries in an automobile accident while on the job. Because of physical limitations resulting from this accident, B accepted the position of “modified letter carrier” in 1997. In this new position B did not actually carry mail but rather worked at the station answering telephones, helping at the window, issuing post office box keys, dealing with customer complaints, and performing other administrative duties. After the appointment of a new station manager in 2004, B experienced turmoil at work and was reassigned to carrying mail. After she returned to carrying mail, B began to have more pain. The new manager, as well as other supervisors, made work life difficult for B by scrutinizing her work more closely than that of other employees, retaliating against her because she requested medical accommodations, and creating an overall hostile work environment for her. B experienced severe stress and emotional difficulties as a result.
B filed complaints against the Postal Service, claiming violations of Title VII of the Civil Rights Act of 1964 (which makes it illegal for employers to discriminate against their employees or retaliate against them for filing discrimination complaints) and §501 of the Rehabilitation Act of 1973 (which prohibits a Federal Government employer from discriminating against a qualified person with a disability or retaliating against her for filing a discrimination complaint). The EEOC Administrative Law Judge awarded B non-pecuniary damages in the amount of $70,000 for emotional distress which was proximately caused by the discrimination of USPS’ employees against her. The ALJ’s decision stated that B suffered from depression, anxiety, sleep problems, and post-traumatic stress disorder, and that the conditions were either caused by and/or exacerbated by the actions which were found to be discriminatory but specifically found that B’s physical pain was not caused by USPS’ discriminatory actions. The ALJ explained that B experienced significant physical distress and pain as the result of actions which were not found to be discriminatory, and that her conditions were exacerbated by non-discriminatory actions which occurred during the same time period that the discriminatory actions were also taking place.
The Postal Service paid the $70,000 to B in 2011 and reported the payment as “Other Income” on Form 1099-MISC. B did not report the $70,000 as income, treating it as exempt damages for physical injury, presumably relying on the regulatory exclusion for damages for emotional distress attributable to physical injury.
In holding hat the $70,000 was not excludable from B’s income, the Tax Court noted that the EEOC decision was clear in attributing the $70,000 to discrimination and not to physical injury. The Tax Court further noted that the EEOC decision stated that B’s physical distress and pain was exacerbated by non-discriminatory actions and that, had the physical pain and emotional distress been caused by the discriminatory actions, B would have been entitled to non-pecuniary damages of $100,000 rather than $70,000. Those circumstances made it clear that the $70,000 was not attributable to physical injury and, accordingly, not excluded from income under §104(b)(2).
This case illustrates the factual fine points that may arise in distinguishing between damages attributable to physical injury (which are non-taxable) from those attributable to emotional distress (which are taxable). Notably, the Internal Revenue Service dropped its claim for an accuracy related penalty at trial, apparently conceding that B had “substantial authority” for excluding the $70,000 from her income.