Recent U.S. Tax Court Decision Highlights Issues Regarding the Tax Treatment of Damages for Stress-Induced Physical Ailments

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In two cases decided in 2010, the U.S. Tax Court indicated 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 Tax Court’s July 11, 2012, decision in Blackwood v. Commissioner, T.C. Memo 2012-190, the taxpayer did not satisfy this standard, highlighting the difficulty of establishing that damages compensating for stress induced physical ailments are excludable from income.

Section 104(a)(2) of the Internal Revenue Code provides that damages received on account of personal physical injuries or physical sickness are generally excluded from income. However, section 104(a) expressly states that “emotional distress” is not a physical injury or physical sickness. Thus, damages compensating for emotional distress are generally taxable.

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