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Emotions run high over tax-free damages

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Normally, damages received from a lawsuit are tax exempt only if paid on account of personal physical injury or physical sickness. But a controversial new case, decided last year, allowed a taxpayer to collect tax-free damages for emotional distress.

Facts: The taxpayer claimed that her former employer “blacklisted” her for disclosing certain environmental hazards. As a result, she allegedly suffered mental and emotional injuries, including grinding her teeth, dizziness, anxiety attacks and shortness of breath. Eventually, the court awarded the taxpayer damages of $45,000 for “emotional distress” and $25,000 for injury to her business reputation.

Initially, the Federal Appeals Court for the District of Columbia ruled that it was unconstitutional to limit the tax exclusion to physical injuries. Therefore, those damages should be tax-free.

Tax reversal: Now the court has vacated its ruling. After a rehearing in which it analyzed the applicable constitutional law, the court said the award did not qualify for the tax exemption. (Murphy, CA-DC, 7/23, 07)

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