A monetary recovery (i.e. settlement or judgment) that is compensation for bodily injury is generally not considered “gross income” and not subject to income tax. (Internal Revenue Code §§104-106) The policy behind this rule is that such monetary compensation is meant to make the injured party whole again, to “compensate” for what he or she has lost as a result of the injury, not to provide a windfall.
However, in order to be exempt from income tax, the plaintiff’s damages must be brought about by “physical” injury. Damages for purely emotional distress not caused by some physical injury (e.g. emotional distress caused by discrimination in the workplace) may, in fact, be considered “gross income” and therefore subject to taxation. (U.S. v. Burke (S.Ct. 1992)) Likewise, punitive damages are taxable as “gross income.” (O’Gilvie v. U.S. (S.Ct. 1996)) Punitive damages, which are intended to punish the defendant rather than compensate the plaintiff, are rarely imposed in civil courts because more than just negligent conduct is required. The defendant must have acted with “malice, oppression, or fraud” in injuring the plaintiff and this must be proven by “clear and convincing “ evidence. (i.e. with near 100% certainty).
In determining whether damages for personal injury are to be considered “gross income” and, therefore, subject to income tax, great weight is given to the settlement agreement, the contract which the parties sign to resolve the case. Therefore, it is important to craft the language of the settlement agreement to state that the compensation being received by the plaintiff is for “bodily injury” or “physical injury” if there is, in fact, a physical component to the damages suffered by the plaintiff.
Caveat: These are guidelines only. There are no guarantees when you are dealing with the IRS. Please make sure to consult your tax advisor.