Mental Health Matters: It’s Time for Congress to Update 26 USC § 104(a)(2)

Blog Post | 111 KY. L. J. ONLINE | November 29, 2022

Mental Health Matters: It’s Time for Congress to Update 26 USC § 104(a)(2)

By: Ryan Crum, Staff Editor, Vol. 111

It would not comport with reality to assume that many Americans associate the Internal Revenue Code (hereinafter "The Code"), the codification of federal tax laws, with any degree of kindness or compassion. There are, however, a few provisions within The Code that legal scholars suggest are altruistic.[1] One such provision is 26 U.S.C. § 104(a)(2), which excludes from gross income “damages received [ ] on account of personal physical injuries or physical sickness.”[2] The reasoning for this exclusion rests partly on the sympathetic view that “the taxpayer has suffered enough.”[3] This sympathy, however, is not limitless, as evidenced by the provision's contrasting treatment of emotional distress damages as generally includible in gross income.[4]

Disparate treatment of emotional distress is not entirely surprising, given the “long history of discrimination against individuals with mental illness in the United States.”[5] Nevertheless, (I) the science and (II) the law indicate that the § 104(a)(2) distinction is outdated. Congress should, therefore, review the provision and seek to extend the exclusion to damages resulting from emotional distress.[6]

I. The Science. 

The science regarding mental and emotional health is relatively unambiguous and indicates that “Mental and physical health are equally important components of overall health.”[7] Therefore, engaging in strictly elementary analysis, if Congress was solely concerned with "suffering," it is not apparent how a taxpayer awarded emotional distress damages has inherently suffered any less than a taxpayer awarded damages for a physical injury. 

The legislative history, however, indicates that Congress considered additional factors beyond anguish.[8] The House Committee Report supports the differing treatment with the proposition that “Damages received on a claim not involving a physical injury or physical sickness are generally to compensate the claimant for lost profits or lost wages that would otherwise be included in taxable income.”[9] In other words, the report suggests that damages received for emotional distress generally do not include damages for medical expenses, pain and suffering, and loss of life's pleasure.[10]

Congress's reasoning, however, is not realistic. Plaintiffs regularly receive various categories of damages for emotional distress, beyond compensation for lost profits or wages.[11] More varying damage awards make sense, given the science. Emotional distress can have brutal consequences and can lead to the development of anxiety and depression,[12] conditions that make an individual vulnerable to numerous other chronic illnesses.[13]

II. The Law. 

The Committee Report provides only one additional reason for the disparate treatment of emotional distress damages—consistency in the law.[14] Prior to 1996, § 104(a)(2) did not include the word “physical.”[15] Instead, it simply provided that “[G]ross income does not include any damages received [ ] on account of personal injury or sickness.”[16] Some courts interpreted this language broadly, even extending the exclusion to cases “under the Age Discrimination and Employment Act.”[17] Not all courts, however, interpreted the provision so extensively; therefore, the tax treatment of damage awards, particularly those in cases not involving physical injury or sickness, was anything but consistent.[18] The report states, “The confusion as to the tax treatment of damages [ ] has led to substantial litigation, including two Supreme Court cases within the last four years.”[19] Congress believed limiting the exclusion to physical injuries and sickness would remedy any confusion and lead to a more consistent tax treatment of damage awards.[20] 

In 1996, limiting the exclusion might have been the most effective way to provide uniformity in the law. In retrospect, however, extending the exclusion would provide even greater consistency. An extension would not only provide for the consistent tax treatment of damages, just as the 1996 change did, but it would also allow The Code to match other areas of the law that are taking a modern approach to mental and emotional health. Take, for example, The Mental Health Parity and Addiction Equity Act (hereinafter “MHPAEA”). The MHPAEA is “a federal law that [ ] prevents group health plans and health insurance issuers that provide mental health [ ] benefits from imposing less favorable benefit limitations on those benefits than on medical/surgical benefits.”[21] The MHPAEA provides just one example of Congress’s movement toward a modern understanding of mental and emotional health.[22]  

In favor of its passage, Congresswoman Betty McCollum remarked that “[The MHPAEA] ends discrimination against patients seeking treatment for mental illness [ ] by requiring that benefits that are offered for physical health are also available for mental health.”[23] Extending the § 104(a)(2) exclusion to damages resulting from emotional distress would, likewise, serve the goal of ending the discriminatory treatment of mental health. An extension would ensure that the sympathetic tax treatment offered for damages resulting from physical injury and sickness would also be available for mental and emotional distress damages. 

III. Conclusion. 

It is time for Congress to review and extend the outdated § 104(a)(2) exclusion to damages resulting from emotional distress.[24] Taxpayers who receive emotional distress damages have, like those who receive damages for physical injuries and sickness, “suffered enough.”[25] An extension maps with a modern understanding of mental and emotional health science and Congress's movement towards keeping up with it.

[1] Stephen A. Lind, Daniel J. Lathrope & Heather M. Field, Fundamentals of Federal Income Taxation 183 (20th ed. 2022).

[2] 26 U.S.C. § 104(a)(2) (emphasis added); see also 26 C.F.R. § 1.104-1(c) (the Treasury Regulation related to § 104(a)(2)).

[3] Lind, Lathrope & Field, supra note 1, at 183 (“[O]ne who has incurred some types of personal injury should not additionally suffer injury to one’s purse in the form of tax liability on the receipt of some financial recompense.”).

[4] Id. at 184; 26 U.S.C. § 104(a); 26 C.F.R. § 1.104-1(c)(1).

[5] Joni Roach, Discrimination and Mental Illness: Codified in Federal Law and Continued by Agency Interpretation, 2016 Mich. St. L. Rev. 269, 269.

[6] It is worth mentioning that this article is not the first noting that the distinction ought to be revisited. See, e.g., Simon de Carvalho, Does the Tax Code Believe Women?: Reexamining 26 USC § 104(a)(2) in the #MeToo Era, 87 U. Chi. L. Rev. 1345, 1345 (2020) (A comment “scrutiniz[ing] the ways in which § 104(a)(2) systematically disadvantages the people most likely to bring such harassment and discrimination claims—female and minority taxpayers.”); Jeremy Babener, Paul Isaac Jr., Rebekah Miller & Tacker LeCarpentier, Getting Back to Fairness in Taxing Invisibly Injured Victims, Bloomberg Tax (Aug. 24, 2022, 04:45 AM), https://news.bloombergtax.com/tax-insights-and-commentary/getting-back-to-fairness-in-taxing-invisibly-injured-victims (arguing that § 104(a)(2) is “outdated and unfairly taxes victims of invisible injuries”).

[7] About Mental Health, Center for Disease Control and Prevention (June 28, 2021), https://www.cdc.gov/mentalhealth/learn/index.htm#print;  see also Sandro Galea, Mental Health Should Matter as Much as Physical Health, Psychology Today (Mar. 25, 2019), https://www.psychologytoday.com/us/blog/talking-about-health/201903/mental-health-should-matter-much-physical-health (“The health of the mind is just as important as the health of the body.”). 

[8] H.R. Rep. No. 104-586, at 142–43(1996).

[9] Id. at 143.

[10] See Dan B. Dobbs, Paul T. Hayden & Ellen M. Bublick, The Law of Torts § 479 (2d ed. 2022) (discussing the three basic categories of tort damages).   

[11] See Zuckerman Law Whistleblower Practice Group, Emotional distress damages in employment discrimination and harassment cases, Nat’l L. Rev. (Sept. 13, 2022), https://www.natlawreview.com/article/emotional-distress-damages-employment-discrimination-and-harassment-cases (“[E]motional distress damages can cover a range of harms, including: [ ] loss of enjoyment of life and mental anguish . . . .”).

[12] See Margaret T. Davis, Sophie E. Holmes, Robert H. Pietrzak & Irina Esterlis, Neurobiology of Chronic Stress-Related Psychiatric Disorders: Evidence from Molecular Imaging Studies, Chronic Stress (Thousand Oaks), Dec.–Jan. 2017, at 1 (“[C]hronic stress plays a significant role in the onset of severe and impairing psychiatric conditions. . . .”).

[13] Kyle J.J. McLachlan & Catharine R. Gale, The effects of psychological distress and its interaction with socioeconomic position on risk of developing four chronic diseases, J. Psychosomatic Rsch., June 2018, at 79

(“Clinical depression and anxiety have been linked with the development of a variety of chronic diseases.”).

[14] H.R. Rep. No. 104-586, at 142–43.

[15] Id. at 142.

[16] Id.

[17] Id. at 142–43. Employment law cases played a rather major role in Congress’s decision to change § 104(a)(2); Jeremy Babener, Paul Isaac Jr., Rebekah Miller & Tacker LeCarpentier, supra note 6 (Congress was motivated by “an abusive tax strategy used by employers and employees,” by which “[e]mployees were avoiding tax [on] severance payments” using § 104(a)(2)).  

[18] H.R. Rep. No. 104-586, at 143.

[19] Id.

[20] See id.

[21] The Mental Health Parity and Addiction Equity Act (MHPAEA), CMS.gov, https://www.cms.gov/CCIIO/Programs-and-Initiatives/Other-Insurance-Protections/mhpaea_factsheet.   

[22] See Rachel Roubein, Congress is turning attention to mental health, The Wash. Post (Feb. 9, 2022, 08:08 AM), https://www.washingtonpost.com/politics/2022/02/09/congress-is-turning-attention-mental-health/ (“[M]ultiple health panels are launching bipartisan work to craft legislative packages addressing the nation’s mental health [ ] crisis.”).

[23] 154 Cong. Rec. E2296-02 (2008).

[24] One well-reasoned suggestion is to “treat[ ] as taxable any damages stemming from lost wages or back pay and as excludable all other compensatory personal injury civil damages.” Carvalho, supra note 6, at 1388.

[25] See supra notes 1, 3 and accompanying text.