Stressed-Induced Physical Ailments - 1

In a 2010 Tax Notes article, attorney Robert Wood asks: "is physical sickness the new emotional distress?" Recent Tax Court decisions highlight both the tax issues raised by damages for stress-induced physical ailments resulting from physical sickness and the need for careful tax planning when seeking such damages.

S2KM reviewed federal legislative and regulatory tax history related to emotional distress damages as well as recommendations for related legislative changes in a prior blog post. To summarize:

• As the result of a 1996 amendment, section 104(a)(2) now exempts from federal income tax “damages (other than punitive damages) received … on account of personal physical injuries or physical sickness.”
• Section 104(a) now also provides "emotional distress shall not be treated as a physical injury or physical sickness" for purposes of section 104(a) (2).
• However, damages received on account of emotional distress that are attributable to a physical injury or physical sickness are excludable.
• The related legislative history provides that “emotional distress” includes “physical symptoms (e.g., insomnia, headaches, stomach disorders) which may result from such emotional distress.”
• In a private letter ruling issued in 2000 (“the bruise ruling”), the IRS established “the observable bodily harms” standard in a case involving sexual assault and harassment in an employment context: “we believe that direct unwanted or uninvited physical contacts resulting in observable harms such as bruises, cuts, swelling and bleeding are personal physical injuries under section 104(a)(2).”
• Although the 2012 regulations for IRC section 104(a)(2) confirm that damages for emotional distress attributable to a physical injury or physical sickness are excluded from income under section 104(a)(2), they do not provide any explanation to help define “physical” or “physical sickness”.

Some of the most challenging "emotional distress" cases, from a tax perspective, involve damages for stress-induced physical ailments resulting from physical sickness. The U.S. Tax Court has provided guidance for such cases in three recent and related decisions:

• Domeny v. Commissioner, T.C. Memo 2010-9.
• Parkinson v. Commissioner T.C. Memo 2010-142.
• Blackwood v. Commissioner, T.C. Memo, 2012-190.

In an article published July 19, 2012 titled "Recent U.S. Tax Court Decision Highlights Issues Regarding the Tax Treatment of Damages for Stress-Induced Physical Ailments", attorneys Jeremy Babener and Neil Kimmelfield summarize these cases and offer advice for taxpayers seeking damages for stress-induced ailments.

According to their article, the U.S. Tax Court indicated in Domeny and Parkinson "that damages compensating for stress-induced physical ailments may be tax-free where (1) the taxpayer can demonstrate that the damages were actually received on account of those ailments and (2) the physical nature of the ailments was verified by a physician, preferably based on objective medical evidence rather than the taxpayer’s subjective report of symptoms."

In the more recent Blackwood case, however, (where the taxpayer suffered insomnia, migraines, nausea, and pain in her back, shoulder, and neck) Babener and Kimmelfield state: "the taxpayer did not satisfy this standard, highlighting the difficulty of establishing that damages compensating for stress-induced physical ailments are excludable from income."

Based upon these cases, Babener and Kimmelfield conclude:

• Taxpayers seeking damages for stress-induced physical ailments will have difficulty excluding such damages under IRC section 104(a)(2) unless they " (1) obtain a medical diagnosis during the underlying dispute and (2) emphasize diagnosed physical ailments in communications with the defendant..."
• It remains uncertain whether taxpayers who obtain medical diagnoses will receive receive tax-free treatment for stress-induced physical ailments that are less acute what were present in the Domeny (multiple sclerosis) or Parkinson (heart disease) cases.

In an article titled "Tax-free Physical Sickness Recoveries in 2010 and Beyond", written prior to the Tax Court's Blackwood decision, attorney Robert Wood offered the following additional advice based upon his review of the Domeny and Parkinson cases:

1. "The facts matter and your proof of the facts matter. To exclude a payment on account of physical sickness, you need evidence that you really made the claim and that the payer was aware of it, and at least considered the claims in making the payment.
2. "Proving that you were struck isn’t part of physical sickness, but proving that you had demonstrable sickness is. You’ll need evidence of medical care, and evidence that you were claiming the payer caused your condition or caused it to worsen.
3. "The courts and the IRS shouldn’t be put in the position of trying to figure out which payments were for which claims. Spend the time to nail down as much as you can in the settlement agreement. Very frequently the IRS will accept an explicit allocation and will not go behind it.
4. "Be reasonable. If you are allocating which payments are for which claims, do not go overboard. Don’t allocate $10 to wages in an employment dispute. Don’t allocate 90 percent of a recovery in an intentional infliction of emotional distress case to physical injuries or physical sickness.
5. "When there isn’t much of a record of medical expenses and discovery in the litigation, consider what other documents you can collect at settlement time. A letter from the plaintiff’s attorney saying why the physical sickness claims were strong may help. A letter from a treating physician or an expert physician may help. Declarations may be even more persuasive than letters. Prepare what you can at the time of the settlement, or at the latest, at tax return time. Do as much as you can contemporaneously. Don’t wait for an audit to gather those things."