Getting Back to Fairness in Taxing Invisibly Injured Victims

Today’s rules unfairly tax victims of invisible injuries, including many instances of sexual abuse and PTSD. When victims sue for justice and win, their recoveries replace value they previously lost. From 1918 to 1996, the US Treasury and Congress exempted these amounts from tax because they “make the victim whole.” Congress changed the rule in 1996 with good intentions, but the legislation was unintentionally broad. And since then, the IRS has interpreted the legislation using a now-dated understanding of the key language used: “physical injuries.”

It’s time to fix this—for victims of sexual abuse and post-traumatic stress disorder at a minimum. We see this problem every day as we serve plaintiffs, defendants, counsel, and others involved in personal injury litigation.

Taxing the Good With the Bad

In 1996, Congress recognized an abusive tax strategy used by employers and employees. Employees were avoiding tax by treating severance payments as tax-free compensation for personal injuries. Congress responded by limiting tax-free treatment to recoveries for personal physical injuries and physical sickness. The House and Senate Committees based this policy on the assumption that non-physical recoveries are “generally [intended] to compensate the claimant for lost profits or lost wages that would otherwise be included in taxable income.”

Congress was right to tax severance compensation but wrong to treat victims of non-physical injuries like departing employees. The House and Senate committees went further, writing that taxation of emotional distress recoveries should extend to recoveries for “physical symptoms (e.g., insomnia, headaches, stomach disorders) which may result from such emotional distress.” The IRS and courts have implemented that writing, taxing recoveries for emotional distress except when resulting from physical harm.

Interpretations and Overtaxation

Making things worse, the IRS and courts have interpreted Congress’ use of the word “physical” in ways that tax victims that you wouldn’t expect. In 2000, the IRS relied on the dictionary definition of physical injury: bodily harm or hurt, excluding mental distress, fright, or emotional disturbance.

Thus, the IRS ruled that a claimant must pay tax on her settlement with her employer for unwanted sexual touches followed by a sexual assault. Because she didn’t suffer “observable harms (e.g., bruises, cuts, etc.),” that portion of her settlement was taxable.

The US Tax Court held that a claimant must pay tax on her settlement for wrongful arrest. She was handcuffed, patted down, and forced to remove her bra in front of police officers. The court held that neither those harms nor her “physical restraint and physical detention” constituted “physical injuries.”

And last year, the court seemed to imply that victims must pay tax when settling for PTSD. The decision ignores years of medical research demonstrating that PTSD involves significant, physical changes in brain chemistry. That research has been noted by the IRS National Taxpayer Advocate in its pleas for a change in tax policy. Nontax courts have taken a similar view. For example, an Oklahoma appellate court held that PTSD constitutes a “physical injury” for purposes of the state’s workers’ compensation benefits.

On the other hand, the US Tax Court has implied that settlement proceeds are tax-free when received for as little as a “pinch” that was “just sore to the touch.” Because it resulted in a small contusion, it met the definition of a physical injury.

Inconsistent Fairness

From time to time, the IRS has creatively helped victims achieve tax-free treatment by assuming or ignoring certain facts. For example, in a minor’s sexual abuse case, the IRS presumed that physical injuries occurred. And in a published notice, the IRS concluded that restitution payments under the Trafficking Victims Protection Act are always tax-free even in the absence of physical injuries.

Although the IRS’ creativity helps individual claimants, the rest face uncertainty and unfair taxation. Conceivably, the IRS could expand its interpretation of “physical injury,” even by looking to other federal laws. After all, federal law defines “physical pain” to constitute bodily injury for purposes of criminal liability for tampering with consumer products. And courts have ruled that under federal law, the physical injury requirement for a prisoner rights suit is satisfied if the prisoner suffered excessive coldness, dampness, or an extended denial of exercise.

The IRS could benefit many by changing its interpretation of the phrase “physical injury,” and there might even be a benefit from new legislation that clearly treats compensation for “invisible injuries” in the same manner as physical injuries. Compensation for both types of harm is intended to make the victim whole. Based on our experience advising those involved in these cases, there’s particularly great need, and consistent unfairness, in cases involving sexual abuse and PTSD.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Jeremy Babener is the founder of Structured Consulting and previously served in the US Treasury’s Office of Tax Policy. He consults for businesses on strategy, partnerships, and marketing.

Paul Isaac Jr. is president of the Society of Settlement Planners and director of operations for Precision Resolution. He helps personal injury claimants maximize eligibility for Medicare and other government benefits.

Rebekah Miller is president of the American Association of Settlement Consultants and settlement consultant at Sage Settlement Consulting. She advises plaintiffs and trial lawyers on settlement planning.

Tacker LeCarpentier is president of the National Structured Settlements Trade Association and president of Settlement Planning Services. He specializes in the use of structured settlements to benefit plaintiffs and trial lawyers.