Mind Games

IRS may soon treat all judgements for mental anguish equally.

Let's say you're driving to your office, carefully minding the traffic and the speed limit. All of a sudden, seemingly from out of nowhere, a trash truck (belonging to a competitor, thank goodness) runs a stop sign and smashes into your car.

Aside from what happened to your car, which is now a total loss, you are banged up, bruised and severely shaken. An emergency medical unit arrives to carry you to a hospital for treatment. After you are discharged, you return home for a couple of days of recuperation before returning to work. At the direction of your doctor, you begin regular physical therapy sessions to deal with your injuries.

Later, you contact a lawyer who files a lawsuit against the waste company, alleging negligence on the part of its driver. Following a verdict or a settlement, you recover a sizable money judgment against the company, reflecting earnings lost when you weren't able to work, past and projected expenses for medical care and follow-up treatment, the fair market value of your car, and pain and suffering, including mental and emotional anguish.

Your lawyer is going to take his or her fee out of the proceeds. But, what about the United States Treasury? It won't demand a dime. The Internal Revenue Code specifically excludes from gross income “damages (other than punitive damages) received … on account of personal physical injuries or sickness.” [26 U.S.C. § 104(a)(2)] Also, whatever you receive for the value of the car is deemed no taxable gain. Now, let's assume you got to work without incident, but instead encountered racial or religious discrimination or sexual harassment on the job. As a result, you developed acute attacks of depression or anxiety, which sent you to a psychotherapist. Maybe you filed charges against your employer, who then retaliated and fired you.

You receive an award or settlement reflecting back pay (if you were off the job while regaining your mental health or looking for new employment), reduced future earnings, lost retirement benefits, compensation for emotional suffering, unreimbursed treatment costs and perhaps attorney's fees. This time, however, there's a tax bite on everything except legal and medical expenses. The Internal Revenue Code provision mentioned earlier also says that emotional distress “shall not be treated as a physical injury or a physical sickness” even if it produces physical symptoms. Thus, whatever part of the award or settlement is attributable to the worker's mental or emotional anguish is fully taxable, but the part linked to the cost of “medical care [for] emotional distress” is tax-free.

The disparity in the tax treatment of damages for mental suffering in these different settings may stem from prior congressional skepticism about claims based on personal sensitivities to an office culture or atmosphere versus claims arising out of actual physical trauma.

Whatever the assumptions, if the House and Senate can agree on the terms of the Civil Rights Tax Relief Act of 2007, it would be a move toward equalizing the treatment of awards and settlements for victims of employment discrimination and civil rights violations, putting them on the same footing as individuals who are injured in car accidents or other similar incidents. Mental anguish damages would not be taxed.

That would be a load off anybody's mind.