What's excludable? Despite amendment, IRC Sec. 104 leaves some questions unanswered.

• Author: Wood, Robert W.
• Position: FEDERALTAXATION

Internal Revenue Code

Sec. 104 excludes from income damages for personal physical injuries or physical sickness. Sound simple? Hardly. Tax advisers have long lamented the lack of clarity surrounding this provision, even though it's been in the tax law since the 1930s.

In 1996, largely in response to plaintiffs in employment cases excluding emotional distress damages, Congress amended Sec. 104 to require "physical," as opposed to merely "personal," injuries. However, the statute does not define "physical."

The IRS position, as determined through private letter rulings and case law, is that you need demonstrable physical harm--cuts, bruises, broken bones--that were sustained in a physical battery. Taxpayers usually favor an expanded interpretation that includes physical sickness. After all, the statute excludes from income damages for physical injuries or physical sickness. Yet, ambiguity reigns.

Distinguishing between mere symptoms of emotional distress (no exclusion) and physical sickness (excludable) isn't easy, which leaves taxpayers with a tough choice: forgo claiming the exclusion or claim it and fight about it later.

RECENT CASES

The Supreme Court in Commissioner v. Schleier [(515 US at 323, 337 (1995)] said that to qualify for the exclusion, a taxpayer must establish that prosecution or settlement of an underlying claim is based on tort or tort-type rights, and that the receipt of damages is on account of personal physical injuries or physical sickness.

Many courts make it tougher still. In Lindsey v. Commissioner [T.C. Memo 2004-113, aff'd by 422 F.3d 684 (8th Cir. 2005)], the Eighth Circuit ruled that to satisfy the second criterion set forth in Schleier, you must show a direct causal link between the damages recovered and the physical injuries or physical sickness in question.

In this case, Lindsey suffered from hypertension and stress-related symptoms, including insomnia, fatigue and occasional indigestion. The Eighth Circuit ruled that these were symptoms of emotional distress, not physical sickness. Plus, the court stated that the defendant knew nothing about any physical sickness or physical injury claims. The court found no direct causal link between the payment and Lindsey's maladies.

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EMOTIONAL DISTRESS: SICKNESS VS. SYMPTOMS

In Mumy v. Commissioner [T.C. Summ. Op. 2005-129], a woman sued her employer for sexual harassment, requesting $500,000 in compensatory damages and $500,000 in punitive damages...