According to the IRS, the general rule regarding taxability of amounts received from settlement of lawsuits and other legal remedies is Internal Revenue Code (IRC) Section 61. This section states all income is taxable from whatever source derived, unless exempted by another section of the code. IRC Section 104 provides an exclusion from taxable income with respect to lawsuits, settlements and awards. However, the facts and circumstances surrounding each settlement payment must be considered to determine the purpose for which the money was received because not all amounts received from a settlement are exempt from taxes.
Awards and settlements can be divided into two distinct groups to determine whether the payments are taxable or non-taxable. The first group includes claims relating to physical injuries, and the second group is for claims relating to non-physical injuries. Within these two groups, the claims usually fall into three categories:
- Actual damages resulting from physical or non-physical injury;
- Emotional distress damages arising from the actual physical or non-physical injury; and
- Punitive damages
Prior to August 21, 1996, IRC Section 104(a)(2) did not contain the word “physical” with regard to personal injuries or sickness. The Code was amended (SBJPA, PL 104-188) to exclude from gross income “the amount of any damages (other than punitive) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness”. The IRS has consistently held that compensatory damages, including lost wages, received on account of a personal physical injury are excludable from gross income with the exception of punitive damages.
Damages received for non-physical injury such as emotional distress, defamation and humiliation, although generally includable in gross income, are not subject to Federal employment taxes.
Emotional distress recovery must be on account of (attributed to) personal physical injuries or sickness unless the amount is for reimbursement of actual medical expenses related to emotional distress that was not previously deducted under IRC Section 213.
As a result of the amendment in 1996, mental and emotional distress arising from non-physical injuries are only excludible from gross income under IRC Section 104(a)(2) only if received on account of physical injury or physical sickness.
Punitive damages are not excludable from gross income, with one exception. The exception applies to damages awarded for wrongful death, where under state law, the state statute provides only for punitive damages in wrongful death claims. In these cases, refer to IRC Section 104(c) which allows the exclusion of punitive damages.
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