If you’ve dabbled in the tax law at any point since, oh…1913, you may have picked up on the fact that the IRS is in the business of taxing accessions to wealth. In other words, if you go to bed at night richer than when you woke up, Uncle Sam wants his cut. The Internal Revenue Code accomplishes this goal via Section 61, which provides the general rule that gross income “means all income from whatever source derived,” language so inclusive it would cover everything from your paycheck to the mob money you found stashed in your thrift-store piano to the $50 you won on the Falcons +11. In fact, Section 61 is so inclusive, when applying the tax law, it’s safe to assume that unless some specific Code section allows you to exclude an accession to wealth from your income, you’ve got to pay tax on it.
WASHINGTON, DC – APRIL 15: The Internal Revenue Service (IRS) building stands on April 15, 2019 in … [+]
Section 104 is one such provision. It provides an exclusion from gross income for “the amount of any 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.” As we’ll discuss more fully below, the flush language of Section 104(a) goes on to provide that emotional distress is not treated as a physical injury or physical sickness, and thus, payments to compensate a taxpayer for emotional distress are not tax-free.
But how do we differentiate between personal injury and emotional distress? For example: what is an eating disorder? Is it an emotional issue, or a physical ailment? I have no idea, and sure wouldn’t want to be the one charged with making the determination.
With an area so grey, you might think that Section 104 would wind up the subject of a lot of litigation, and you’d be right. But as you may have guessed, with a provision so nuanced, there will always be new situations that Section 104 has never previously contemplated. This past Friday, one such fact pattern ended up the center of an IRS Private Letter Ruling, and it’s an interesting, albeit sad, scenario.
But before we dive into the PLR , let’s take a look at the general workings of Section 104, and then a few cases from the past decade so we can lay some groundwork.
Section 104, In General
If you sue somebody and either 1) win the suit, or 2) negotiate a settlement, because you’re richer than when you woke up, your award is fully taxable under Section 61. As we previously established, however, there is an exception under Section 104(a), which provides that income does not include any damages received on account of “personal physical injuries of physical sickness.” The exclusion does not extend, however, to 1) punitive damages, or 2) payments attributable to previously deducted medical expenses.
As mentioned earlier, the Code makes clear that for these purposes, “emotional distress” is not treated as a physical injury or physical sickness. Making matters worse, the legislative history to Section 104 clarifies that physical symptoms arising from emotional distress–like insomnia, headaches, or stomach disorders–are also not considered personal injuries or physical sickness. This means that if the genesis of your legal claim is emotional distress, than the full amount of compensation — even if meant to make you whole for resulting physical symptoms — is taxable. On the other hand, as a bevy of case law has established, if the genesis of the claim is a physical injury, than the full amount of the payment — other than punitive damages — will be excludable under Section 104, even if part of the payment is meant to compensate you for emotional distress arising from the physical injury.
Thus, when determining whether a taxpayer’s award or settlement payment is excludable under Section 104, you’ve got to get to the bottom of the original claim: what caused the taxpayer to sue in the first place? If it was an emotional injury, any award is taxable. If it was a physical injury, provided the award or settlement agreement supports that contention — you have a tax-free payment on your hands. Let’s see how the case law tackles the issue.
Barbato: the genesis of the claim
In Barbato v. Commissioner, T.C. Memo 2016-13, the taxpayer worked for the U.S. Postal Service. In 1991, she was in a car accident while on the job, and injured her neck.
Due to the resulting physical limitations, Barbato took a different role at the USPS; one that did not require her to carry mail, but rather to stay at the station, answer calls, help at the windows, and deal with customers.
A new office manager was hired in 2004, however, and things quickly soured for Barbato. She was forced to return to carrying mail, which only worsened her neck pain. In addition, Barbato alleged that the new manager made work life tough for her by scrutinizing her work more closely than other carriers and retaliating against her when she requested medical accommodations.
As a result of the hostile work environment, Barbato began to experience severe stress and emotional difficulties to go along with her physical pain.
Frustrated, Barbato filed suit against the USPS for discriminating against her because of her prior neck injury. In 2011, Barbato won her suit, and was awarded $70,000. In the decision, the judge stated that “Barbato 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.”
Most importantly from a tax perspective, the judge also found that Barbato’s physical pain was not caused by USPS’s discriminatory actions, but rather from the previous car accident.
In the year of receipt of the $70,000 payment, Barbato did not report the income on her tax return, arguing that it was excludable under Section 104. Barbato believed that while the payment was made as an award from a suit claiming emotional distress, the discrimination that was the center of the suit would have never arisen had she not suffered a previous physical injury. Thus, in her opinion, the ultimate genesis of her claim was a physical injury, which permitted the payment to be excluded under Section 104.
The IRS, however, had other ideas. The Service argued that the payment was made “on account of” emotional distress, not physical injury, while also relying on prior case history to argue that depression and anxiety are not physical injuries. The Tax Court agreed on all counts, concluding that even though the original incident that led to the discrimination was a physical injury, the reality was that the motivation behind Barbato’s legal claim was emotional distress, which included her depression and anxiety. Thus, while the genesis of the injury may have been physical, the genesis of the claim that led to the award was emotional distress. As a result, the $70,000 represented taxable income.
Barbato does a great job of illustrating the all-important “genesis of the claim” principle as it applies to Section 104. Let’s take a look at three more cases that reflect just how nuanced Section 104 can be.
Amos: you don’t have to prove you were physically injured, you just have to prove you got paid because you claimed to be injured.
Amos v. Commissioner, TC Memo 2003-329 is perhaps the most high-profile of all the Section 104 cases. After all, the alleged physical injury happened on live television, when former Chicago Bull Dennis Rodman kicked a sideline cameraman during a game.
The cameraman immediately went to the hospital, complaining of groin and back pain, though no medical professional could find a definitive injury. Nevertheless, six days later Rodman and Amos settled for $200,000, with no allocation of the payment made between the taxpayer’s claim of physical injury and a nondisclosure agreement that was part of the deal.
The Tax Court concluded that $120,000 of the payment was intended to compensate the cameraman for his claims of physical injury, noting that it doesn’t matter if Amos was really injured by Rodman; rather, all that mattered was that Rodman paid Amos, in part, because of the claim that Amos had been injured.
Parkinson: when emotional distress leads to physical INJURY — rather than merely a “symptom” — payments for the injury are tax-free under Section 104.
The courts have concluded on many occasions that claims for emotional distress may be tax free if they arise out of physical injury. To illustrate, if you get hit by a car and suffer severe injuries, but are also so emotionally traumatized that you refuse to cross the street for the next four years, Section 104 would protect you from paying tax on any payments attributable to the emotional distress. It is also well-worn territory that if you originally suffer from emotional distress – as was the case in Barbato — any payments for physical symptoms of that distress are not tax-free under Section 104. But what is a physical symptom, and how do we differentiate one from a physical injury?
In Parkinson v. Commissioner, T.C. Memo 2010 – 142, the taxpayer worked 70 stressful hours a week at a medical center, which eventually led to a heart attack. While recovering, he was constantly harangued by his co-workers to return to work, which led to a SECOND heart attack. And even then, while recouping from his second near-death experience, the same co-workers called him while in the hospital and told him to get back to the job. Parkinson wisely quit, and sued for “severe emotional distress” before settling for $350,000. Parkinson excluded the payment from his taxable income pursuant to Section 104.
The IRS argued that because Parkinson’s suit mentioned only the emotional distress caused by his co-workers, the entire payment was taxable. The Tax Court, however, disagreed. In doing so, the court stated that while payments for physical symptoms arising from emotional distress are not excludable under Section 104, a HEART ATTACK is more than a mere symptom; rather, it’s a physical injury in its own right. As a result, the court concluded that one-half of the $350,000 payment was excludable under Section 104 as compensation for the heart attack, with the other half taxable as payment for emotional distress.
Perez: you can’t exclude payment for physical injury you consent to.
In Perez v. Commissioner, 144 T.C. 4, (2015), the taxpayer contracted to sell her eggs to women who struggled to conceive on their own. During 2009, Perez went through two donation cycles and was paid a total of $20,000.
For each donation, Perez entered into contracts that clearly stated that she was not selling her eggs, intimating instead that she was being compensated for her physical suffering:
“Donor Fee: Donor and Intended Parents will agree upon a fee for Donor’s time, effort, inconvenience, pain, and suffering in donating her eggs. This fee is for Donor’s good faith and full compliance with the donor egg procedure, not in exchange for or purchase of eggs and the quantity or quality of eggs retrieved will not affect the Donor Fee. The parties plainly acknowledge and agree that the funds provided to the Donor shall not in any way constitute payment to Donor for her eggs.”
Based on the language of the contract, Perez believed that the $20,000 she received in 2009 was to compensate her for the physical injuries she suffered as part of the egg donation process, and thus, fit within the ambit of Section 104 and was excludable from her taxable income. As a result, Perez did not report the $20,000 of taxable income, despite the fact that she was issued a Form 1099 in that amount.
The IRS disagreed, arguing that regardless of the contractual language, the $20,000 Perez received was in exchange for services provided; in essence, while Perez may not have been selling her eggs, she was providing a service when she went through the process of donating her eggs.
With some trepidation, the Tax Court took on the issue of whether the $20,000 Perez received was in fact taxable compensation, or if it represented a tax-free recovery of physical damages.To that end, the court noted something unique about the taxpayer’s argument compared to all previous Section 104 cases — in this instance, the injuries were both anticipated and consensual; in fact, they were of the exact nature that Perez was advised to expect when she entered into her contract. Thus, Judge Holmes concluded:
The injury here , as painful as it was to Perez, was exactly within the scope of the medical procedures to which she contractually consented. Twice. Had Donor Source or the clinic exceeded the scope of Perez’s consent, Perez may have a claim for damages. Her physical pain was a byproduct of performing a service contract, and we find that the payments were not made to compensate her for some unwanted invasion against her bodily integrity but to compensate her for services rendered.
As a result, the amounts paid to Perez, and presumably to all future egg donors, represented taxable income. Now, let’s turn our attention to the recently issued PLR, and take a look at what it has to add to our understanding of Section 104.
PLR 20195004: Section 104 applies to damages caused before birth
Last Friday, the IRS published a private letter ruling that, to the best of my knowledge, addresses a fact pattern never before contemplated by Section 104. Unfortunately, a PLR is not a court case, so we don’t get an in-depth view of how the Service applied the statutory and regulatory language — to say nothing of the judicial precedent — to the facts in the ruling; rather, all we get is a quick summary of the law and the Service’s conclusion. Nevertheless, the result is an interesting one.
In the ruling, the taxpayer contracted with a clinic to provide her with a suitable anonymous donor egg and perform an embryo transfer via in vitro fertilization. The clinic, however, failed to fulfill its obligation to test the donor egg or embryo for certain genetic mutations.
The taxpayer gave birth to a child from the implanted embryo, and soon after, it became clear that the child suffered from an unnamed genetic condition the clinic failed to test for. Because of being born with the condition, the child will suffer from multiple physical, cognitive, and behavioral disabilities.
The taxpayer filed a complaint against the clinic seeking damages for the physical injuries as well as the taxpayer’s own emotional distress. The taxpayer and clinic went on to settle for an undisclosed lump sum.
The IRS concluded that the settlement was intended to compensate the taxpayer for the physical injuries suffered by her child — as well as the emotional distress of both mother and child — as a result of the clinic’s failure to detect the genetic condition.
Again, to my knowledge, this is the first time the IRS has extended the application of Section 104 to physical injuries “caused” prior to the harmed individual being born.
Even more fascinating, it appears to be the rare situation — if not the only one — where physical injury was caused by omission rather than overt action. For example, a “physical injury” for purposes of Section 104 was previously defined in Private Letter Ruling 200041022 as “Direct unwanted or uninvited physical contacts resulting in observable bodily harms such as bruises, cuts, swelling and bleeding are personal physical injuries under Section 104(a)(2).” Then, in Stadnyk v. Commissioner, T.C. Memo 2008-289, in holding that false imprisonment, alone, was not a physical injury, the tax court stated that for payment under Section 104 to be excludable, “something more than a physical act is required– the person has to be injured as result of the physical act.” Based on this history, for the IRS to allow for compensation for physical injury caused by omission appears to be an expansion of the previous application of Section 104.
The conclusion is in no way incorrect; it’s just, well…unique. The taxpayer is holding the clinic liable for the lifelong physical pain and suffering her child will endure, and despite the fact that the harm was caused by omission rather than any overt action of the clinic, the IRS rightfully concluded that the payments are meant to compensate the taxpayer for that pain, regardless of how — or when — it was inflicted.
A few weeks ago, I explained to my graduate school class that Section 104 is among the more fascinating in the Code, if for no other reason that a never-before-seen fact pattern is not particularly unique. Given the blurred line between physical pain and emotional distress, and the continuing evolution of how things like depression and anxiety are viewed by the medical community, the application of Section 104 will continue to evolve as well.