Cain on the Taxation of Tort Damages

Patricia Cain has posted to SSRN Taxation of Tort Damages.  The abstract provides:

Under Section 104(a)(2) of the Internal Revenue Code, damages for personal injury can only be excluded from income in cases in which the plaintiff is physically injured. If the plaintiff instead suffers emotional distress from the injury, even if the distress is so great that it results in physical injury or physical sickness, then all damages are taxable. This “physical injury” or “physical sickness” requirement was added to Section 104(a)(2) in 1996. This article, as many before it have done, questions the wisdom of that intended bright line. It does so by exploring the history in tort law of the treatment of emotional distress injuries, which used to require a physical injury for recovery. Tort law has moved beyond that strict requirement, whereas tax law seems to have moved backwards. Interestingly, the physical injury does not need to be that of the taxpayer. Wrongful death and loss of consortium damages are excluded even though the taxpayer’s only injury is an emotional one. Finally, the article questions the soundness of a recent Ninth Circuit opinion, Blum v. Commissioner, upholding a Tax Court opinion, that ruled that malpractice damages could not be excluded because the lawyers did not physically harm the plaintiff. They paid her the damages, however, to reimburse her for the damages she would have won from the hospital she had been suing for physical injuries. Since the malpractice settlement was “in lieu of” an award for physical injury damages, it would seem the better alternative would be to exclude the settlement payment under Section 104(a)(2).