Vertical Advisors, LLP
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The quick answer is damages or awards received for physical injuries or sickness are generally not taxable.  However, punitive damages or awards are generally taxable if they are paid to compensate a taxpayer for non-personal injuries.  Internal Revenue Code (IRC) Section 104 is the area of law that defines the taxable treatment of compensation for injuries or sickness.  In general if a taxpayer received an award or damages for a personal injury or sickness, then the income can be excluded from taxable income.  If a taxpayer received punitive damages for non-personal injury or a non-sickness then it is typically going to be treated as taxable income.  I say typically, because tax law allows damages received for nonphysical injury or sickness to be reduced for any medical expenses which meet the IRC definition of 213.  Or the attorneys might craft the settlement to be worded as a physical damage.

There are many court cases regarding these issues.  One to look at for damages received for non-physical damages is O’Gilvie, Kelly v. U.S. (1996, S Ct) 78 AFTR 2d 96-7454.

IRC section 104 states, the gross income doesn’t include:

• amounts received under workmen’s compensation
  for personal injuries or sickness;
• amount received through accident or health
  insurance for personal injuries or sickness;
• amounts received as a pension, annuity or similar
  allowance for personal injuries or sickness resulting from active
  service in the armed forces of any country or in the Coast and Geodetic Survey
  or the Public Health Service, or as a disability annuity payable under the
  provision of section 808 of the Foreign Service Act of 1980; and
• amount received by an individual as disab9ility
  income attributable to injuries incurred as a direct result of a
  terrorist or military action.

Now let’s look at some other forms of damages.  Damages received for emotional distress are generally taxable.  Emotional distress is generally not considered a physical injury or physical sickness for purpose of the exclusion from income or damages received on account of physical injury or physical sickness.

As defined in H Rept No. 104-586 (PL 104-188) p.144:  “The term “emotional distress” includes physical symptoms (e.g., insomnia, headaches, stomach disorders) which may result from the emotional distress.  Thus, depression, sleep disorders, or high blood sugar caused by an individual’s stress from a wrongful termination were not considered personal physical injury or physical sickness, and were not excluded from his gross income.  Similarly, emotional distress damages for injury to human capital were damages received on account of personal
nonphysical injuries or nonphysical sickness, and not excluded from gross income.”   However, damages for emotional distress are excluded from gross income to the extent the damages are either.  (1) attributable to physical injury or physical sickness; or (2) not in excess of the amount paid for medical care (as defined by IRC section 213(d)(1)(A).

Sexual discrimination awards are generally taxable if received after November 22, 1991 as they typical are not received for physical injury or physical sickness.

Punitive damages or damages received in a civil action regarding wrongful death is generally not taxable.  This area of tax law needs to be taken into consideration with the applicable state laws.  In summary, the taxability of awards, damages and punitive damages are generally taxable unless, the taxpayer can prove they were received for personal injuries or sickness. State laws need to be taken into consideration.

As always the application of tax law is based on the specific taxpayer issues, and attributes.  Please discuss your situation with your tax advisor.