July 13, 2023

Tax Implications of Emotional Distress Settlements: A 2023 U.S. Tax Court Ruling

In the context of law, a settlement is a resolution between disputing parties about a legal case, reached either before or after court action begins. This agreement, typically in the form of a contract, is most often related to disputes involving the payment of money and serves to resolve the conflict without the need for a court trial.

Settlements can occur in a wide variety of legal contexts, from personal injury claims to complex business disputes, but they all share the same basic principle: the parties voluntarily agree to resolve the issue without proceeding further with litigation.

Taxation of settlement funds can be quite complicated, as it greatly depends on the nature of the legal claim that was the basis for the settlement. Generally, the IRS considers settlement money to be taxable income, with a few exceptions.

The general rule of thumb is that settlement proceeds from lawsuits are taxable. However, IRC section 104(a)(2) offers an exception, rendering any damages received on account of personal, physical injuries or physical sickness as non-taxable. The key for a taxpayer to fit within this exclusion is to demonstrate a direct link between the damages received and the personal injuries incurred. The nature of the claim that gave rise to the settlement is what courts primarily consider.

Consider the case of a trailblazing woman within the San Francisco Fire Department, who was amongst the few women to graduate from the Fire Academy. Unfortunately, her achievement was met with disdain by her male colleagues, leading to a hostile work environment marked by disparaging comments, equipment sabotage, and unseemly actions towards her personal belongings.

Her persistent complaints only served to intensify the harassment and soon leaked into the public sphere. In 2017, she filed a lawsuit to end the harassment, and a settlement was reached in 2018, awarding her $382,797.70, inclusive of attorney’s fees. Her CPA advised her not to report this money, which led the IRS to issue a Notice of Deficiency.

The court highlighted that the settlement stated the payment would be treated as general damages for personal injury, including emotional distress, and not as back wages. The court also noted that her complaint did not allege any physical injuries, but rather focused on sex discrimination, retaliation, and emotional distress.

Despite the distress experienced, the court ruled that IRC section 104(a) explicitly states “emotional distress shall not be treated as a physical injury or physical sickness.” As a result, her settlement was deemed taxable income. This case underscores the importance of understanding the tax implications of settlement proceeds and the necessity to navigate these issues correctly.

As mentioned earlier, settlement proceeds for personal physical injuries or physical sickness are usually non-taxable under IRC section 104(a)(2), provided that the damages have a direct causal link to the injuries sustained. However, other types of settlements, like those for emotional distress or defamation, are typically taxable. If a settlement is considered taxable, the recipient must report it as income on their tax return.

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