Taxpayer Cannot Exclude Emotional Distress Settlement from Taxable Income

William Delaney, EA
Westwood, MA

Edward Collins worked for a utility company located in New Jersey, where he “was subjected to a racially hostile work environment.”  Eventually, Collins “left work on disability leave” (depression, general anxiety disorder, hypertension, blood clots, and muscle spasms).

In a subsequent lawsuit he alleged that he had “suffered severe emotional distress and anxiety, with physical manifestations, including high blood pressure.”  Collins did not demand compensation for any physical injury or sickness.

The suit was settled and payments were described as follows:

1.  $90,000 payable to the attorneys (why does that always appear first?).
2.  $15,000 for unreimbursed medical expense.
3.  $85,000 for emotional distress.
4.  $85,000 for compensation, less withholding taxes.

On line 21 of Mr. Collin’s federal 1040 for the year he reported line 3 (emotional distress) as “other income.”

On line 36, Mr. Collins deducted the same $85,000 as reported on line 21, apparently without specifying a reason.  The IRS challenged the deduction and the matter landed in Tax Court.

Why the deduction?  In Court, Mr. Collins argued that the $85,000 payment was mischaracterized in the settlement with his former employer when “more accurately, it should have been shown as for physical injury and physical sickness…”  That would make it non-taxable, reasoned Collins.  The IRS argued that the agreement “clearly states that the disputed $85,000 was paid for emotional distress, and, even if the Settlement Term Sheet were silent, it would be clear that the payment was not for physical injuries.

The Court concluded that “An express allocation in the settlement agreement is generally binding for tax purposes providing the agreement was entered into by adversarial parties acting at arm’s length and in good faith.”  Bagley v. Comm., 105 T.C. 396, 406 (1995).  “The intent of the payer, and not the recipient, is critical in determining the validity of an express allocation in a settlement agreement.”  Guitierrez v. Comm., T.C. Memo 2011-263 (2011).

Finally, the Court looked at Lindsey v. Comm., T.C. Memo 2004-113 (2004) to see if Mr. Collins’ ailments would meet the statutory definition of an excludible illness or Injury.  In Lindsey the Court said “we classify hypertension as the type of injury or sickness that Congress intended to be encompassed within the definition of emotional distress” (Lindsey at 688).  Thus, the Court concluded that Mr. Collin’s $85,000 payment related to emotional distress and not to physical sickness.

The Court also noted that line 36 of form 1040 (where the deduction was taken) was “a computational line, not calling for the inclusion or deduction of any amount.”  While that is generally true, there have been occasional exceptions where the IRS has authorized taxpayers to make an entry which would only appear on that line (with a memo notation to the left). 

The lessons to be learned?  If it is supposed to be non-taxable, get the proper language into the agreement.  Don’t try to fix it on your income tax return.  Doesn’t work that way!
And, if you have a deduction against line 21 income, take the deduction on line 21.  Don’t try to take it elsewhere as this is a big red flag for an audit.  See Edward Collins v. Comm., T.C. Summary Opinion 2017-74 (9/11/17).