This article is designed to outline the tax treatment of post-traumatic stress disorder (PTSD) damages for plaintiffs. PTSD has become a household illness particularly among our soldiers returning from Iraq and Afghanistan. Numerous media outlets have provided coverage regarding the high level of suicide in the war zone and high level of mental trauma among veterans. In some cases, it would seem that the entire force is fighting the war while being medicated with Prozac. Is this somehow a new disease?
It seems in past wars, an accurate diagnosis was lacking and the problem was untreated, masked by alcoholism, domestic abuse, violent crime, chronic unemployment and homelessness. PTSD is also being diagnosed in victims of child abuse and many other scenarios including workplace trauma. Attorney Rob Wood has cited the Argentinean writer Jose Narosky who observed that in war, there are no unwounded soldiers.
Throughout this tax series, I have been examining the tax treatment of various types of damages. As we have learned, it is not always clear cut. Prior to the addition IRC Sec 104(a)(2), taxpayers and their counsel tried to categorize as much of the damages as “emotional distress” so that they could receive tax-free treatment on settlements for emotional distress
Congress’ response was in the opposite direction. The IRS took the litigating posture that it wanted broken bones and bruises as proof of damages “on account of physical injury and sickness. Unfortunately, with an illness such as PTSD, the bruises and brokenness are all internal.
What is PTSD?
In 2000, the American Psychiatric Association revised the diagnostic criteria for PTSD in its diagnostic and Statistical Manual of Mental Disorders (DSM-IV-TR)(1). The diagnostic criteria includes a history of exposure to a traumatic event including two criteria and symptoms from each of three clusters- intrusive recollections, avoidant/numbing symptoms and hyper arousal symptoms.
Criterion A: Stressor
The person has been exposed to a traumatic event in which both of the following have been present”
The person has experienced, witnessed or been confronted with an event that involved actual or threatened death or serious injury.
The person’s response involved intense fear, helplessness or horror.
Criterion B: Intrusive Recollection
The traumatic event is persistently re-experienced in at least one of the following ways:
Recurrent and intrusive distressing recollections of the event including images, thoughts or perceptions.
Recurrent distressing dreams of the event.
Acting or feeling as if the traumatic event were recurring such as hallucinations, or flashbacks.
Intense psychological distress at exposure to internal or external cues that symbolize or resemble an aspect of the traumatic event.
Physiologic reactivity to internal or external cues that symbolize or resemble an aspect of the traumatic event.
Criterion C: Avoidant/Numbing
Persistent avoidance of stimuli associated with the trauma and numbing of general responsiveness as indicated by at least three of the following:
Efforts to avoid thoughts, feelings or conversations associated with the trauma.
Efforts to avoid activities, place or people that arouse recollections of the trauma
Inability to recall an important aspect of the trauma.
Markedly diminished interest or participation in significant activities.
Feeling of detachment or estrangement from others.
Restricted range of affect (unable to have loving feelings)
Sense of foreshortened future (does not expect to have a career, marriage, children or normal life span)
Criterion D: Hyper Arousal
Persistent feelings of increasing arousal (not present before trauma). Indicated by at least two of the following:
Difficulty falling or staying asleep.
Irritability or outbursts of anger
Exaggerated startle response.
Criterion E: Duration
Duration of the disturbance (symptoms in B, C, and D) is more than one month.
Criterion F: Functional Significance
The disturbance causes clinically significant distress or impairment in social or occupational functioning. Acute symptoms have duration of less than three months and chronic symptoms have a duration lasting longer than three months.
PTSD is more than extreme anxiety. In addition to emotional symptoms, the victim experiences changes in neuroendocrinology and neuro anatomy. These changes affect brain function as well as how the brain physically exists. The sufferer experiences changes at a molecular level.
A Review of IRC Sec 104(a)(2)
The Small Business Protection Act of 1996 added IRC Sec 104(a)(2) to the Internal Revenue Code changing the landscape for the taxation of settlements and damages. The new section made a small but significant change by limiting tax-free treatment as a result of personal “physical” injuries and “physical” sickness.
IRC Sec 104(a)(2) excludes from gross income the amount of any damages (other than punitive 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
Emotional distress is generally not considered a physical injury or physical sickness. However, damages for emotional distress attributable to a physical injury or physical sickness are excluded from income under section 104(a)(2).
Internal Revenue Bulletin 2012-12 added final regulations which had been pending since 1996 and substantial amounts of litigation regarding the “on account of physical injury and physical sickness” test of IRC Sec 104(a)(2).
The final regulations adopt the provision under the proposed regulations that delete the requirement that to qualify for exclusion from gross income, damages received from a legal suit, action, or settlement agreement must be based upon “tort or tort type rights
The Tax Treatment of PTSD
In order to receive tax free treatment for damages, damages must be on account of physical injury or sickness. At first glance, PTSD would appear to be psychological. However, recent research has demonstrated that PTSD leaves observable physical footprints on the brain that can lead to other debilitating problems. PLR 200041022 cites the need for observable bodily harm in order to meet the requirements of IRC 104.In Murphy v IRS, 493 F.3d 170 (D.C. Cir 2007), anxiety, humiliation and embarrassment were not enough to constitute physical injury or sickness.
Nevertheless, IRC Sec 104(a)(1) excludes amounts received under worker’s compensation acts as compensation for personal injuries or sickness. IRC Sec 104(a)(4) excludes pension and annuity payments for personal injuries or sickness resulting from active service in the armed forces. In Kiourtsis v. Commissioner, T.C. Memo 1996-534, the Tax Court did not dispute that payments for PTSD were excludable IRC Sec 104(a)(4).
Some Movement in the IRS Position
In Part 3 of this series, I examined the tax treatment of damages for sexual abuse. The IRS in the area of sexual abuse is moving away from its bright line test that all damages “on account of personal physical sickness and injury” must be readily observable. The IRS Tax Payer Advocate has addressed Congress on this issue. In an IRS Chief Counsel Advice Memoranda (CCA 200809001), the Office of Chief Counsel cited a sexual abuse fact pattern. In the fact pattern, the plaintiff suffered physical injury as a result of sexual abuse as a child.
A significant amount of time had passed since the events making it difficult to establish the extent of the physical injuries suffered as a result of the abuse. Nevertheless, the IRS conceded that it was reasonable to presume that all damages were the result of physical injuries and that the emotional distress suffered was attributable to the physical injuries suffered years before. Interestingly, the author of CCA 200809001 was also the author of PLR200041002 that concluded that any damages received for unwanted physical contact without any readily observable bodily contact were not received on account of personal physical sickness or injury. These more recent pronouncements seem to indicate a new trend in the IRS position on sexual abuse.
There are several learning points to consider. First, the IRS view point on damages and settlements that are not inherently physical in nature is developing. Second, PTSD symptoms are also demonstrably physical.
The difficulty of PTSD injuries is that they are not visible to the naked eye. All of the bruises and brokenness is internal. Nevertheless, sophisticated diagnostic tools are able to demonstrate physical changes to brain function and chemistry. After combatting taxpayer abuse in the area of damages for emotional distress, modern science has caught up to the IRS. The Taxpayer’s Chief Advocate has moved the ball down the field in regard to psychologically based injuries which are not readily observable. PTSD should be seen as an injury which meets the “physical” requirements of IRC Sec 104(a)(2).