The Tax Law Report

Allocation of Settlement Agreement

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.

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Compensatory Damages & Equal Protection

I am posting this decision because the Tax Court addresses one of my arguments in a prior post. Section 104(a)(2) excludes from gross income compensatory damages for physical injury or sickness. The flush language of 104(a) excludes emotional distress from the definition of physical injury or sickness.

Mr. Hennessey was an officer in the U.S. Air Force. In 1993, he was selected for involuntary separation by the U.S. Airforce's Reduction-In-Force Board. The Board was directed by the Secretary of the U.S. Air Force to consider factors such as gender and race, particularly females and minorities, in making their selections. The justification given was past "individual and societal attitudes, policies, and practices."

In 1998, Mr. Hennessey, among others, filed a class-action law suit alleging violation of their equal protection rights under the 5th amendment because the Board "improperly considered race and gender." The suit was settled and Mr. Hennessey received a $30,000 lump-sum payment.

Mr. Hennessey did not include the lump-sum payment on his 2004 tax return and of course the IRS quickly addressed Mr. Hennessey's apparant oversight. The IRS wins here because the payments were not for physical injury or physical sickness as required by section 104(a).

Among Mr. Hennessey's many arguments is the same equal protection argument I suggested in my previous post - namely, that their is no rational basis for treating physical injuries different than mental injuries. The Tax Court dismisses Mr. Hennessey's equal protection argument by citing a Sixth Circuit decision holding the statute constitutional. Young v. United States, 332 F.3d 893 (6th Cir. 2003). Mr. Hennessey, however, lives in Missouri which is in the Eight Circuit. I assume if an Eigth Circuit decision existed the Tax Court would have cited one. Maybe Mr. Hennessey will appeal this issue to the Eigth Circuit.

I will write a post soon analyzing the Young decision.

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Compensatory Damages and Emotional Distress

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.

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