The Hellesens were both attorneys for State Farm. In 1995, they filed a lawsuit against State Farm alleging, among other things, sexual harassment, discrimination, and wrongful discharge. During the lawsuit against State Farm, Mr. Hellesen stated he suffered chest pains, stomach problems, weight loss, etc., all related to being sexually harassed.
In 1997, the lawsuit was settled and the Hellesen's received a check from State Farm for $273,500. They did not file their 1997 tax return until 2000, nor did they report the proceeds from the settlement.
The Hellesens tried to exclude the settlement proceeds from gross income pursuant to section 104(a)(2). This section excludes from gross income damages received because of physical injury or sickness. The section's flush language excludes emotional distress from the definition of physical injury/sickenss.
While the settlement agreement with State Farm mentioned physical injury and sickness, it did not specifically allocate damages. Furthermore, the Hellesens's complaint did not allege physical injury or sickness. These two points were fatal to their 104(a)(2) exclusion argument.
I previously suggested that excluding emotional distress from the definition of physical injury and sickness was an archaic notion given the advances in physchiatric science over the last ten years. While a policy change could take quite a long time, an intermediate solution might be to use those advances in science to prove physical injury in these types of lawsuits. The Court does not come out and say it, but the implication is that if damages are specifically allocated to physical injury or sickness then the taxpayer might have a chance.