Mrs. Shelton was sexually harassed by her former employer. As a result of an EEOC class action case against her employer, Mrs. Shelton received $123,500 through a settlement. In exchange for the settlement, Mrs. Shelton signed a release that indicated the proceeds were for pain and suffering, mental anguish, etc.
Mrs. Shelton did not report the proceeds of the settlement on her 2004 tax return. She believed, based on discussions with the IRS, that the settlement proceeds were excludable under section 104(a)(2). This section excludes from gross income damages (other than punitive) received on account of physical injuries or physical sickness. The IRS assessed a deficiency because her damages were received for emotional distress and not physical injury. The Tax Court upheld the IRS's determination because section 104(a) also says that for purposes of 104(a)(2), emotional distress shall not be treated as a physical injury.
The IRS also assessed a 20% underpayment penalty for negligence. The Tax Court rejected the IRS's assessment citing Mrs. Shelton's good faith attempt to understand and apply the tax law. The Tax Court found Mrs. Shelton's argument that her emotional distress manifested itself in physical ways reasonable. Nonetheless, the law clearly excludes emotional distress despite its obvious physical impacts.
The decision here is technically correct. Congress has chosen to exclude emotional distress from the myriad of physical injuries that can occur. What's more, Congress is probably free to exclude emotional distress from the category of physical injury despite the fact that modern science can prove Mrs. Shelton physically suffered from her employer's harassment.
Congress needs to change the law. Excluding emotional distress from the definition of physical injury is archaic, particularly in light of the Mental Health Parity and Addiction Equity Act of 2008. If Congress sees fit to require insurance companies to treat mental health benefits on par with other health benefits, then Congress should re-evaluate its rationale for excluding emotional distress from the definition of physical injury.
I might even go so far as to say that Congress is discriminating against a "class of people" - those with mental injuries. Thus, the carve out for emotional distress might be unconstitutional under the 5th amendment. Since people with mental injuries are neither a suspect class nor gender based, it would receive rational basis treatment. Under the rational basis test, Congress would need to assert a legitimate reason for excluding mental injury from the definition of physical injury. Given the strides modern science has made in the area of mental health, and given the MHPAE Act, I am not sure Congress could meet this very light burden.