Case — Taxation of Legal Award

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TL Case Summ

THE QUESTION

Are damages received from a harassment lawsuit includable in income?

THE DISPUTE

Taxpayer Says: Compensatory damages are excludable from income because the damages are compensation for physical symptoms caused by harassment.

Internal Revenue Service Says: The damages were paid as compensation for emotional distress and are taxable.

THE LAW

From Internal Revenue Code Section 61(a):  Gross income generally includes all income from whatever source derived.

From Internal Revenue Code Section 104(a)(2): Damages (other than punitive damages) received on account of personal physical injuries or physical sickness may generally be excluded from gross income.

From Internal Revenue Code Section 104(a): Emotional distress is not treated as a personal physical injury or physical sickness except for damages not in excess of the amount paid for medical care attributable to emotional distress.

THE CAUSE OF THE DISPUTE

As a general rule, when damages from a lawsuit are based on a claim of physical injury or sickness, you can exclude the amount you receive from income. Emotional distress is not a physical injury.

In this case, the taxpayer was afflicted with physical symptoms caused by the emotional distress of the harassment. She contends the proceeds from the lawsuit were paid to compensate her for those physical symptoms.

The IRS argues the proceeds were compensation for the harassment, not for the physical symptoms experienced as a result of the harassment.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 22KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Sorry, wrong answer :(
Right answer!
For the IRS. While the emotional distress manifested itself in physical symptoms, the basis of the award was the harassment suit. The award is taxable income.