On January 23, 2012, the Internal Revenue Service (IRS) issued a final regulation that reflects a 1996 law making payments for emotional distress damages taxable as income. The new regulation, cited as 26 CFR 1.104-1(c), makes clear that settlements and awards are taxable unless they are “attributable to a physical injury or physical sickness.” The regulation also restates an exclusion from income for those portions of emotional distress damages that do not exceed the amount actually paid for medical care. So, if a whistleblower can show the amount actually paid for treatment of emotion distress, that portion of a settlement up to that amount can be excluded from income. The full text of the new regulation is available through this link, or in the continuation of this blog entry.
This new regulation emphasizes the need for the bipartisan Civil Rights Tax Relief Act (CRTRA), H.R. 3195, sponsored by Representatives John Lewis (D-GA) and James Sensenbrenner (R-WI), and S. 1781, sponsored by Senators Jeff Bingaman (D-NM) and Susan Collins (R-ME). The CRTRA will exclude all emotional distress damages from the calculation of taxable income, and will allow victims of discrimination and retaliation to use income averaging to avoid the elevated tax rate that can apply to receiving several years of backpay at one time. Advocates are currently working with the Joint Taxation Committee to compute the actual cost of these proposals.
26 CFR 1.104-1(c)
(c) Damages received on account of personal physical injuries or physical sickness–
(1) In general. Section 104(a)(2) excludes from gross income the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness. Emotional distress is not considered a physical injury or physical sickness. However, damages for emotional distress attributable to a physical injury or physical sickness are excluded from income under section 104(a)(2). Section 104(a)(2) also excludes damages not in excess of the amount paid for medical care (described in section 213(d)(1)(A) or (B)) for emotional distress. For purposes of this paragraph (c), the term damages means an amount received (other than workers’ compensation) through prosecution of a legal suit or action, or through a settlement agreement entered into in lieu of prosecution.
(2) Cause of action and remedies. The section 104(a)(2) exclusion may apply to damages recovered for a personal physical injury or physical sickness under a statute, even if that statute does not provide for a broad range of remedies. The injury need not be defined as a tort under state or common law.
(3) Effective/applicability date. This paragraph (c) applies to damages paid pursuant to a written binding agreement, court decree, or mediation award entered into or issued after September 13, 1995, and received after January 23, 2012. Taxpayers also may apply these final regulations to damages paid pursuant to a written binding agreement, court decree, or mediation award entered into or issued after September 13, 1995, and received after August 20, 1996. If applying these final regulations to damages received after August 20, 1996, results in an overpayment of tax, the taxpayer may file a claim for refund before the period of limitations under section 6511 expires. To qualify for a refund of tax on damages paid after August 20, 1996, under a written binding agreement, court decree, or mediation award entered into or issued after September 13, 1995, a taxpayer must meet the requirements of section 1605 of the Small Business Job Protection Act of 1996.