Can Stress Or Depression Reduce Your Income Tax Liability?

By George W. Connelly

Unfortunately, Congress has yet to create a deduction or tax credit for depression or stress, although many taxpayers would like to see it happen as part of Obamacare.  Right now, people who itemize deductions may be able to claim medical expenses for treatment of stress or depression, but the actual deduction is often disappointing because only the amount which exceeds 7% of your adjusted gross income can actually be used to reduce the taxable income. But what if you receive damages for stress or depression? A pair of recent cases decided by the United States Tax Court involving taxpayers with damages for problems in their work environment provides some insight into when and how these elements affect the taxability of the damages received.

Julie Domeny, whose case is reported at T.C. Memo 2010-9, suffered from multiple sclerosis (MS) before she took a position with the Pacific Autism Center for Education, where her duties included community development, fund raising and writing grants.  After a change in supervisors, problems in the workplace caused her MS symptoms to flare up.  They worsened when she found that her supervisor was embezzling funds, and although she notified management of this unlawful work environment, no action was taken.  Ultimately, purportedly because of absence from work, she was notified that she was terminated, and her MS symptoms “spiked.”

Ms. Domeny engaged a lawyer and without filing a lawsuit, they negotiated a very generally worded settlement agreement which failed to specify the exact reason for which she was receiving a settlement.  Part of it was paid to her as compensation, and she reported that on her tax return, but she also received a Form 1099 for a separate part of the award as “nonemployee compensation,” which she did not pay tax on.

I.R.C. § 104(a)(2) provides an exclusion from gross income for the amount of any damages – other than punitive damages – received on account of personal physical injuries or physical sickness.  The statute covers damages whether or not there is a lawsuit or formal agreement.  However, the Section further provides that “emotional distress” shall not be treated as a “physical injury or physical sickness,” to the extent the amounts received exceed the amount paid for medical care attributable to emotional distress.  The issue facing the Tax Court was whether there was a “direct cause or link” between the damages and the personal injuries sustained.  Although the agreement lacked express language specifying the purpose of the compensation, the Court accepted Ms. Domeny’s testimony regarding exposure to a hostile and stressful work environment, and how it worsened her MS symptoms to a point that she was unable to work.  The Court inferred from the manner in which the settlement payment was split that the employer was aware that at least part of her recovery might not have been taxable.  The Court concluded that the payment was to compensate her for the physical injuries resulting from her stress, and excludable.

The Tax Court reached a different result in the case of Marion Wells, who sought to exclude the settlement she received for depression (beyond the amount paid for medical care to treat emotional distress).  The same operative sections of the Internal Revenue Code were at play, but the condition arose from alleged gender discrimination and retaliation.  Ms. Wells’ alleged stress was due to altercations with her supervisor and inaction by her employer about seeking therapy, taking leave and eventually being terminated.  The settlement agreement stated that the amount she received was “as damages for her emotional distress due to depression and other claims, not as wages or back pay.”  She treated the settlement as excludable, but the IRS concluded that it was includable.

The Tax Court agreed with the IRS that the settlement payment was made for emotional distress and that, as a matter of law, it is not excludable from her gross income.  The Court stressed that the settlement was not attributable to physical injury or sickness, but to a nonphysical injury – gender based discrimination and unlawful retaliation.

What do these cases mean for people who are stressed or depressed?  If you have expenses for medical treatment of your condition, be sure to present and discuss them with your return preparer before just deducting them.  If you make a claim for damages, there is a line of demarcation to be wary of:  if you can point to an actual physical sickness as the reason for the damages, you have satisfied an important condition for excluding the recovery from income under I.R.C. § 104.  If not, you will in all likelihood not qualify. In either event, anyone faced with a serious problem should contact their personal tax advisor about the proper treatment of any damages, and encourage the legal representative handling the claim to contact that tax advisor to see if specific language ought to be included in the agreement.  Ms. Domeny won her case without such language, but having a specific identification of the reason for the payment will make it more likely that the amount properly excludable is in fact excluded at tax time.

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