Taxable Income?

The IRS has historically treated compensation for injury or sickness and the emotional aftermath of injury and sickness as nontaxable items. Any damages that constitute compensation due to injuries, whether they are the result of jury verdict or voluntary settlement (including workers’ compensation awards) were tax-free. Historically, this would also extend to emotional distress, anxiety, and depression that frequently accompany injury. New IRS rules, however, provide that compensation for emotional distress which does not arise from a physical injury will now be taxable.

If you receive a damage award which compensates you only for emotional distress, which arose without any physical injury, it is considered taxable income. This is an important concept to know in light of the increased awareness of sexual harassment/wrongful termination cases. In those cases, there is no collision or broken bones, but the victim may suffer significant anxiety, distress, or psychological problems.

By way of example, assume you are in a bad car accident, incur $25,000 in medical bills, and lose $25,000 of income because you can’t work. Obviously, you will undergo pain and suffering and suffer anxiety because you cannot work to support your family, you may experience depression as well. If the case settles for $150,000, all of this money is non-taxable.

These are only general rules, and you should certainly consult an attorney or accountant to determine the tax treatment that a settlement or verdict with respect to your claim will receive.