Are damages received from a harassment lawsuit includable in income?
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.
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
THE COURT’S DECISION
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.
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