Compensation for physical injury or physical sickness is generally not taxable income. Several common components of the same settlement are. Which is which turns on what the money is for, which is why the allocation written into the settlement agreement matters so much.
Generally not taxable
Damages received on account of personal physical injuries or physical sickness are generally excluded from gross income. That covers the medical expenses, the pain and suffering and the emotional distress that flow from the physical injury — the emotional distress is excluded because it originates in a physical injury, not because distress is inherently exempt.
Generally taxable
- Punitive damages. Taxable in essentially all cases, because they punish conduct rather than restore a loss.
- Interest — pre-judgment or post-judgment — is interest income.
- Emotional distress with no physical injury behind it, as in many pure employment or defamation claims.
- Lost wages in non-physical-injury claims, which can also carry employment-tax consequences.
- Previously deducted medical expenses. If you deducted the cost in an earlier year and are later reimbursed, the tax benefit rule can require you to bring that amount back into income.
Allocation is not a formality
A settlement that resolves several claims should say what each portion is for. A clear, arm’s-length allocation supported by the actual facts of the case is far more defensible than a lump figure with no breakdown — and an allocation that plainly contradicts the pleaded case will not be respected simply because both sides signed it.
Attorney fees can be the sharpest trap
Where a recovery is taxable, the claimant may be treated as receiving the entire amount including the portion paid to their lawyer, and the deductibility of those fees is restricted in many situations. That can produce tax on money the claimant never touched. Specific above-the-line deductions exist for certain claim types, notably some employment and whistleblower cases, which is precisely why this needs case-specific advice rather than a general rule.
Before you sign
Tax treatment is far easier to influence while terms are being negotiated than afterwards. A structured settlement can change the picture materially, and liens affect what you actually keep independent of tax. Related: Settlements.
This is general information, not tax or legal advice, and it is not a substitute for advice from a qualified tax professional who has seen your settlement documents. Federal and state treatment can differ.