IRC Section 104(a)(2) excludes from gross income the compensatory damages you receive on account of personal physical injuries or physical sickness, whether the money comes through a lawsuit judgment or a negotiated settlement, and whether it’s paid as a lump sum or over time. Punitive damages are not excluded. Interest is not excluded. Damages for emotional distress standing alone are not excluded. And amounts that reimburse you for medical expenses you already deducted in a prior year get pulled back into income. Getting the line wrong can cost you a 20% accuracy-related penalty on top of the tax.
What the Statute Actually Excludes
Section 104(a)(2) covers “the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness.”1Office of the Law Revision Counsel. 26 USC 104 – Compensation for Injuries or Sickness Once a payment qualifies, the exclusion reaches every compensatory component that flows from the physical harm: medical bills, lost wages, lost earning capacity, pain and suffering, and loss of quality of life.
The exclusion also reaches certain family claims. Damages a spouse receives for loss of consortium are excludable because they are received “on account of” the injured person’s physical injury.2Internal Revenue Service. PLR-110300-99 The same reasoning applies to a parent’s claim for loss of a child’s companionship when the child was physically injured. The test is always whether the payment traces back to someone’s physical harm.
Wrongful death recoveries generally fit within the exclusion for the same reason. Compensatory damages paid to survivors — loss of companionship, lost financial support, funeral costs — arise from the decedent’s physical injury or sickness and are excluded. Punitive damages in a wrongful death case follow the ordinary rule and remain taxable.
The “Physical” Requirement
The word “physical” is doing most of the work in this statute. The IRS requires “observable bodily harm” to qualify: bruises, broken bones, lacerations, internal organ damage.3Internal Revenue Service. Tax Implications of Settlements and Judgments Symptoms triggered by emotional distress — insomnia, headaches, stomach problems, elevated blood pressure — do not qualify as physical injuries or physical sickness, even though they are experienced in the body. The Tax Court reinforced this in Stassi v. Commissioner, holding that inserting the words “physical manifestations” into a settlement agreement was not enough to establish a physical injury. The physical harm has to be real and the causal link to the payment has to be direct.
The practical result surprises people. A settlement for workplace harassment that caused you stress-induced ulcers is taxable, because the ulcers are a symptom of emotional distress rather than a standalone physical injury. If the harasser physically assaulted you, damages flowing from that assault are excludable. Same defendant, same case file, entirely different tax outcome depending on the origin of the injury.
The “on account of” language matters too. There has to be a direct causal chain between the physical harm and the payment. If a car accident breaks your leg and you miss six months of work, the lost-wage portion of your settlement is excluded because it flows from the broken leg. Where the connection becomes attenuated, the exclusion falls apart.
What Stays Taxable
Several categories of damages remain in gross income even when they show up in the same case as an excludable physical injury award.
Punitive Damages
Punitive damages are taxable across the board. The Supreme Court in O’Gilvie v. United States held that punitive damages are not received “on account of” the injury; they exist to punish the defendant, which puts them outside the compensatory purpose that Section 104(a)(2) protects.4Justia US Supreme Court. O’Gilvie v United States, 519 US 79 (1996) A $500,000 compensatory award can be entirely tax-free while a $200,000 punitive award in the same case is fully taxable.
Interest
Pre-judgment and post-judgment interest are always taxable as ordinary income, regardless of whether the underlying damages are excluded.2Internal Revenue Service. PLR-110300-99 If your case took four years to resolve and the judgment includes $30,000 in pre-judgment interest, that $30,000 goes on your return even if every other dollar is tax-free.
Amounts Attributable to Previously Deducted Medical Expenses
Section 104(a)(2) contains a carve-out: the exclusion does not apply to amounts “attributable to (and not in excess of) deductions allowed under section 213” for any prior tax year.1Office of the Law Revision Counsel. 26 USC 104 – Compensation for Injuries or Sickness If you itemized and deducted medical expenses tied to your injury in an earlier year, then later recovered those costs through a settlement, the recovered amount comes into income. You can’t have the deduction and the exclusion for the same dollars.
The recapture is limited by the tax benefit rule under IRC Section 111: only the portion of the earlier deduction that actually reduced your tax gets pulled back in.5Office of the Law Revision Counsel. 26 USC 111 – Recovery of Tax Benefit Items If part of the deduction fell below the 7.5% AGI floor and gave you no benefit, that part isn’t recaptured.6Internal Revenue Service. Topic No. 502, Medical and Dental Expenses If you took the standard deduction in the year of the medical expenses, this rule doesn’t touch you.
Emotional Distress: When It’s In, When It’s Out
Emotional distress damages track the origin of the claim. If you develop anxiety and depression after a car accident that broke your spine, damages for that distress are excluded because they flow from the physical injury. If the emotional distress is the underlying claim — defamation, intentional infliction of emotional distress, employment discrimination without physical contact — the damages are taxable.3Internal Revenue Service. Tax Implications of Settlements and Judgments
One narrow exception cuts in your favor. You can exclude the portion of emotional distress damages that reimburses actual out-of-pocket medical costs attributable to the emotional distress, as long as you didn’t already deduct those costs.1Office of the Law Revision Counsel. 26 USC 104 – Compensation for Injuries or Sickness If emotional distress led to $8,000 in therapy bills and your settlement reimburses that $8,000, that portion is excluded. Everything above the medical costs is taxable.
Employment Cases
Employment settlements are where the “physical” requirement bites hardest. Back pay and lost wages from a wrongful termination, breach of contract, or discrimination case are taxable unless they were directly caused by a personal physical injury.3Internal Revenue Service. Tax Implications of Settlements and Judgments Back pay in a Title VII disparate treatment case is fully includable. Severance and dismissal pay are generally treated as wages subject to both income tax and employment taxes.
Damages for non-physical injuries in an employment case — emotional distress, defamation, humiliation — are included in gross income but not subject to federal employment taxes. Taxable back pay reported on a W-2 costs an extra 7.65% in FICA compared to emotional distress damages reported on a 1099-MISC, so how a settlement is characterized has real cash consequences.
Allocation and Confidentiality Clauses
When a settlement covers both excludable and taxable claims, the written allocation drives the tax outcome. The IRS generally respects a clear allocation that results from arm’s-length negotiation and matches the substance of the dispute. Vague language — “in full satisfaction of any and all claims” — invites the IRS to treat the whole payment as taxable, and the burden of proof to show otherwise sits on you.
An effective allocation names specific dollar amounts. Something like “$300,000 for physical injury damages and $75,000 for emotional distress arising from the discrimination claim” gives you a defensible position. A generic release does not.
Confidentiality clauses complicate the picture. In Amos v. Commissioner, the Tax Court held that payments in exchange for confidentiality, non-disclosure, and non-cooperation agreements are not made “on account of” a physical injury. Those provisions are separate commodities within the settlement, and the portion attributable to them is ordinary income under Section 61(a), even in a case built on physical harm. The court allocated $120,000 of a $200,000 settlement to the physical injury (excluded) and $80,000 to the non-physical provisions (taxable). If your agreement contains confidentiality terms and doesn’t clearly allocate the payment, expect the IRS to argue that part of the money bought your silence rather than compensated your injury.
Reporting on Your Return
Payors of taxable settlements have to report them. Taxable damages other than wages go on Form 1099-MISC, usually in box 3.7Internal Revenue Service. Instructions for Forms 1099-MISC and 1099-NEC Back pay characterized as wages goes on a W-2. Damages excluded under Section 104(a)(2) for personal physical injuries are not reported on a 1099-MISC. Punitive damages are reported on a 1099-MISC even when they accompany a physical injury claim.
If you receive a 1099 for an amount you believe is excludable, report the amount on your return and attach a statement explaining the exclusion. Ignoring the 1099 almost guarantees an IRS notice. Taxable settlement amounts are reported as “Other Income” on Schedule 1 of Form 1040. Underreporting can trigger a 20% accuracy-related penalty when the understatement exceeds $5,000 or 10% of the tax required to be shown, whichever is greater.8Internal Revenue Service. Accuracy-Related Penalty For most lawsuits, that threshold is easy to cross, which is why the physical/non-physical line and a careful allocation are worth the attention before you sign.