Are Emotional Distress Damages In Employment Cases Tax-Exempt?

In Wells v. Commissioner, United States Tax Court Memo 2010-5 (Jan. 5, 2010) the United States Tax Court reiterated that damages received by a plaintiff for emotional distress (manifested in the form of depression) -- suffered as a result of alleged employment-related retaliation -- are not exempt from taxation as a "personal physical injury" under Internal Revenue Code Section 104(a)(2). The Tax Court explained that for the damages to be excludable under this provision, the underlying cause of action must be based in tort or tort-type rights and the proceeds must be damages received on account of personal physical injury or physical sickness. The Tax Court further explained that when, as in the instant case, the amount paid is pursuant to a settlement agreement, the nature of the claim that was the basis for settlement -- and not the validity of the claim -- controls whether such amount is excludable under section 104(a)(2). Althought the Tax Court found that the settlement agreement in the instant case expressly stated that payment was for emotional distress (and not wages), the Court nevertheless held that the payment was in fact "made as damages for emotional distress due to depression and, as a matter of law, such damages, not being attributable to physical injury or sickness, but to a nonphysical injury (namely, her claims of suffering gender-based discrimination and unlawful retaliation with respect to her employment) are not excludable from her gross income under section 104(a)(2) ...."