Settlement amounts received under a settlement agreement that relate to a physical injury or physical sickness are excluded from income and not taxable, while amounts, other than medical expenses, arising from any other non-physical injury or non-physical sickness, such as mental anguish or other emotional damages stemming from the loss of a job, are included in income and are taxable.

But what exactly does this mean?

First of all, there is no dispute that emotional distress is not a physical injury or sickness in and of itself, because § 104(a) of the Internal Revenue Code (IRC) now says exactly that. It states that for purposes of the exclusions from taxable income under IRC § 104(a)(2), “emotional distress shall not be treated as a physical injury or physical sickness.” Not only that, the term emotional distress includes any physical symptoms such as insomnia, headaches and stomach problems that result from emotional distress.

So the key issue for federal income tax purposes becomes whether any damages for which an award is given arose on account of a physical injury of physical sickness. If it can be shown that pain, suffering and emotional distress arose out of a physical injury or sickness, such as an auto accident or cancer caused by radiation exposure, then damages to compensate for those problems are excludable from taxable income. But if those same disorders arose from a non-physical injury, such as employment discrimination or libel, then they cannot be excluded from taxable income, even though the medical expenses incurred for treating these problems can be excluded.

This may seem unfair, but that is the federal tax law as it currently stands. As we said in the previous posts, if you have made a claim under which you will receive a settlement award, determining and documenting exactly what different portions of the award were meant to cover, and how they arose, can have important financial implications for you.

On a more positive note, it’s also important to understand that all damages that flow from a physical injury or sickness are treated as payments received on account of that physical injury or physical sickness. This means, for example, that lost wages can be excluded from taxable income as long as the lost wages resulted from time in which the injured person was out of work as a result of his or her physical injuries.

To pull all of this together, let’s look at an example:

Assume you suffered an on the job personal injury in which you hurt your leg and were required to take time off as a result, then during the time you are not working you are laid off as a result of discrimination. You file a claim against your company asking for payment for your work injury claim and the pain and suffering the disability caused you, as well as for all of the medical expenses related to that injury and back pay for the time you were out of work. You also file a claim for employment discrimination, and ask for lost wages and damages for emotional distress due to the discrimination.

In this case, the damages you were asking for under the first claim could be excluded from taxable income, because they happened on account of your work-related injury. But with respect to the second claim, the award would not be excluded from taxable income, unless, of course, you could make a successful argument that the employment discrimination itself arose out of the physical injury. Now that would be an interesting case.