Sometimes the law is clear, but it doesn’t feel fair. That tension is on full display in Fortune-Paladino v. Commissioner, T.C. Memo. 2025-101. In this case, the Tax Court acknowledged the injustice of what the taxpayer endured, even sympathizing with her plight, but still ruled against her because the Internal Revenue Code was clear.
The Story Behind the Case
Fortune-Paladino worked as a counselor at a halfway house in Pennsylvania. Her supervisor, who was also the owner, repeatedly harassed her with sexually inappropriate comments, propositions, and humiliating “jokes.” When she pushed back, he retaliated. After returning from medical leave in 2014, he fired her in front of staff and residents while yelling obscenities.
Four years later, she sued for sex discrimination and retaliation in federal court. In January 2019, she settled for $135,000, paying $54,000 to attorneys and keeping $81,000.
On her 2019 return, she didn’t report the settlement. The IRS issued a notice of deficiency for $28,354 in tax plus a §6662 penalty of $5,671 .
Why the Settlement Was Taxable
IRC §61 defines gross income as “all income from whatever source derived,” unless specifically excluded. The possible exclusion here was IRC §104(a)(2), which allows damages received “on account of personal physical injuries or physical sickness.”
But emotional distress, humiliation, or reputational harm, no matter how severe, do not qualify unless they stem from physical injury. And the settlement agreement explicitly stated that the payment was only for emotional distress and humiliation, not physical injury .
As Judge Marvel noted, the court was “very sympathetic” to Paladino and acknowledged the “appalling indignities” she endured, but the law was clear: without a physical injury claim, the settlement proceeds were taxable .
Why Reviewing the Settlement Agreement Is Critical
As tax professionals, we aren’t the ones drafting settlement agreements, that’s the attorneys’ job: However we are the ones who must deal with the tax consequences.
That’s why it is essential to read the agreement carefully. The Tax Court in Fortune-Paladino didn’t speculate about what the taxpayer went through; it relied on the exact words in the document. The agreement said the payment was solely for “emotional distress, anxiety, and humiliation” and included a clause titled “No Injuries Alleged.” That language left no opening for exclusion under §104(a)(2) .
For practitioners, this means:
Always request a copy of the settlement agreement when preparing a return.
Look for how damages are characterized: physical injury, emotional distress, lost wages, punitive damages, etc.
Advise clients early that even if their suffering feels like “injury enough,” the IRS will only go by the written words in the agreement.
In other words: we don’t draft, but we must read. Understanding the language upfront is the only way to properly advise clients on what will and won’t be taxable.
The Harsh Reality: Sympathy Doesn’t Change Taxability
This is one of those cases where the court recognized the human unfairness yet still applied the law strictly. Paladino walked away not only scarred from harassment but also facing a tax bill on her settlement.
It highlights a painful truth: emotional pain is real, but the tax code doesn’t treat it as compensable in the same way as physical harm.
The Penalty Issue and How to Avoid It
The IRS initially imposed a §6662 accuracy-related penalty for substantial understatement of income tax. Fortunately for Paladino, the IRS conceded the penalty.
But what if they hadn’t?
A Closer Look at §6662
The §6662 penalty is a common penalty that the IRS assesses. It equals 20% of the underpayment of tax when it arises from:
Negligence or disregard of rules or regulations, or
Substantial understatement of income tax (when the understatement exceeds the greater of 10% of the tax required or $5,000).
The IRS doesn’t have to prove intent, only that the taxpayer got the law wrong in a significant way.
That’s why disclosure is powerful. By attaching Form 8275 (Disclosure Statement) or Form 8275-R (Regulation Disclosure Statement) to a return, taxpayers can show transparency and good faith if they have a reasonable basis for the position. Even if the IRS disagrees with the position, disclosure often prevents the penalty from sticking, since the issue was disclosed.
In settlement taxation cases, where exclusions under §104(a)(2) can be murky, disclosure may be a key tool for protecting clients.
Practitioner Takeaways
Sympathy ≠ exclusion: Emotional distress damages are taxable unless tied to physical harm.
Check the settlement agreement language: The IRS and courts will look closely at how damages are characterized.
Don’t forget attorney’s fees: While deductible in some cases (and deductibility was conceded in this case), fees don’t erase the obligation to report gross settlement proceeds.
Understand §6662: The 20% penalty hits hard but can often be avoided with proper understanding and disclosure.
Use Form 8275 or 8275-R wisely with a reasonable basis: Disclosure demonstrates good faith and may prevent penalties even when tax is still due.
Important caveat: Disclosure doesn’t cure negligence or frivolous positions, and it won’t protect reportable or listed transactions. At a minimum, there must be a reasonable basis for the position.
The Fortune-Paladino case is a stark reminder of how the tax law sometimes feels out of sync with fairness. A victim of harassment secured justice in one sense, but the tax consequences felt unjust.
For practitioners, the lesson is clear: don’t assume sympathy or circumstance will shield a client from tax law. Prepare clients for the tax reality of settlements, read the settlement agreement closely, and use disclosures to protect them from penalties.
Because in tax law fairness is optional, compliance isn’t.