Do Plaintiffs Have to Pay Income Tax on Emotional Distress Awards?

emotional distress

If you represent plaintiffs in civil lawsuits, you often must negotiate the tax withholdings on their settlement awards. It is important to recognize how different legal claims are taxed and to draft your settlement agreements appropriately. Otherwise, your clients could have to pay income tax on emotional distress awards totalling thousands of dollars in lost compensation.

IRS Assessed Income Tax on Workplace Sexual Assault, Physical Injury, and Emotional Distress Awards

Rebecca Tressler was a railroad engineer and road foreman for Amtrak from 1987 to 2009. During her time there, she said she experienced workplace harassment, retaliatory employment practices, sexual assault, physical injuries, stalking, and emotional distress resulting in physical manifestations and post-traumatic stress disorder. She sued the railroad (formally National Railroad Passenger Corp) on October 28, 2009. The case was dismissed on summary judgment and later appealed.

In February 2014, Tressler and Amtrak finally settled the case for $82,500. The settlement agreement waived all Tressler’s claims, including physical injuries, emotional distress, attorney fees and costs. It set out specific payment terms: Amtrak would withhold taxes on $27,500. The remaining $55,000 represented “settlement of Ms. Tressler’s claim for emotional distress damages related to her allegations.” Amtrak paid the settlement on May 1, 2014.

However, Tressler never filed a 2014 income tax return reporting the settlement award as income. The IRS prepared a substitute return including the entire $82,500 as reportable income, and issued a notice of deficiency. Tressler sued for redetermination of the deficiency, claiming that she could exclude at least half, if not all, of the $55,000 balance.

Do You Have to Pay Income Tax on Emotional Distress Awards?

Generally speaking, plaintiffs do have to pay income tax on settlement awards, unless those awards were for “any damages (other than punitive damages) received (whether by suit or agreement) on account of personal physical injuries or physical sickness.” Emotional distress awards generally do not qualify for the exception. However, they may be excluded from income tax if the emotional distress was attributable to physical injury or sickness. So personal injury settlements may often be excluded, but workplace discrimination claims must be examined more closely.

In Ms. Tressler’s case, the settlement agreement framed the payment as for “emotional distress damages” but did not specify that those damages related to her personal injury claims. The Tax Court said:

“We simply cannot accept petitioner’s request to allocate the $55,000 payment among her claims for ‘physical injuries, emotional distress, attorneys’ fees, and costs’ when section 2.2 [of the settlement agreement] attributes the whole $55,000 to her claim for emotional distress damages related to her claims in the lawsuit.”

Extrinsic evidence outside the language of agreement itself may have shown that Amtrak knew of her injuries and “had every reason to compensate” her as a victim of a violent sexual assault. However, the language of the settlement agreement controlled the court’s decision.

Can You Deduct Medical Expenses for Treating Emotional Distress?

While Tressler did have to report her emotional distress awards as income, the Tax Court said she could deduct the portion of those awards used on medical care to treat her emotional distress. This included $6,980 spent on medication and psychotherapist bills from treating her PTSD between 2012 and 2014. However, the burden of proving these amounts rested on the taxpayer. Because Tressler could not document her mental health expenses prior to 2012, she was required to pay income tax on the remaining $48,020 of her emotional distress awards.

This blog has address taxes on emotional distress before, as part of a disability discrimination settlement. In both cases, the issue came down to whether the settlement was paid for emotional distress resulting from physical injuries, the injuries themselves, or illegal discrimination and workplace behavior. Often, once a settlement has been reached, civil attorneys representing injured clients rush to get the settlement agreement signed. However, what both Tressler and Beckett show is that careless drafting of the settlement agreement could cost injured plaintiffs thousands in income taxes on emotional distress awards that are not specific as to their causes. Taking the time to break down the settlement into the plaintiff’s various claims can allow them to exclude portions of the settlement from income tax, and save them money.

Attorney Joseph R. Viola is a tax attorney in Philadelphia, Pennsylvania with over 30 years experience. If you have questions regarding IRS tax exemptions or need to refer your workplace harassment or personal injury client’s tax collections case, contact Joe Viola to schedule a consultation.

Categories: Tax Exemptions, Tax News