Recovery For Emotional Distress Is Taxable--At Least For Now

Posted on Oct 05, 2007
An important question for those who receive damage awards from courts or settlements is the taxability of their recovery of money from their personal injury claim. The general rule is that the amount of damages received by the person on account of “personal physical injuries” or “physical sickness” is not subject to federal income tax. If the injured victim also recovers punitive damages, that recovery is fully taxable to the extent that the payment is exclusively for “punitive” damages. Punitive damages are payments that are ordered for the purpose of setting an example and for punishment of someone for their wrongdoing. Punitive damages are designed to discourage wrongdoing. A related issue of whether money recovered for mental and emotional distress is taxable is currently unresolved. A federal tax law change enacted in 1996 said that emotional distress could not be considered a physical injury or sickness, and therefore payments received for emotional distress would be taxable. The rule before the statutory law change was that any income received would not be taxed if it represented compensation for “personal injuries or sickness.” This included injuries that were both physical and nonphysical (such as emotional distress), said a summary in a recent opinion by a three-judge panel from the District of Columbia Circuit U.S. Court of Appeals. That issue arose in a tax case that has attracted widespread attention over the past year. Although the courtroom battling isn't over yet, the latest verdict is: Yes, that award is fully taxable. The case involves Marrita Murphy, who received the $70,000 after having filed a complaint with the Labor Department against her former employer in a whistle blower lawsuit. She paid taxes on the award and later filed an amended return asking for a refund. The Internal Revenue Service rejected her request. In August of last year, a three-judge panel of the U.S. Court of Appeals for the District of Columbia Circuit ruled in Ms. Murphy's favor, concluding that the award didn't represent income. The court said a 1996 tax-law change was unconstitutional insofar as it permitted taxing damage awards for mental distress and loss of reputation. Later, however that very same court reversed itself and ruled that the money Ms. Murphy received for emotional distress and loss of reputation. Now, Ms. Murphy is asking the full U.S. Court of Appeals for the District of Columbia to review her case. Who knows how far this case may go. For now, at least, you can assume that an award for mental and emotional distress is fully taxable. If you are contemplating settling a personal injury case that has an emotional damages component, be sure that the settlement documents specify that the settlement is for personal injuries only and not for mental distress. By doing so you will not have to fight the battle with the IRS as to whether money paid for emotional distress is taxable.

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