Taxable Damages Explained

One of the prevailing issues that the public has against the government is their continuous belligerence in collecting taxes from any sort of income. This includes the settlements that people get from lawsuits. The Internal Revenue Service field agents follow an audit guide that allows them to determine whether certain lawsuits and settlements are taxable. Structured settlements are also being examined even if the Structured Settlement Protection Act is already in place. As we have mentioned before, sometimes, the way structured settlement agreements are written allow the IRS the opportunity to tax a portion if not the full amount.
Section 61 of the Internal Revenue Code (26 U.S.C.) states that all income from whatever source derived is taxable, unless specifically excluded by another IRC section. This means that taxation is the default and non-taxable income is the exemption. Section 104(a)(2) is the only provision that specifically addresses income exclusions for any type of lawsuit proceeds.
Settlements that arise from personal injuries are long established to be tax-exempt. However, there are still prevailing discussion on physical versus non-physical (mental anguish) injuries and sickness, and whether punitive damages are received on account of personal injuries. Damages like depression are argued to be something that should be taxable.
Legally, this has long been settled by the Congress. In 1996, the Congress resolved the controversy by amending section 104(a)(2). Congress now restricted the tax exclusion to just physical injuries or physical sickness. Since the August 21, 1996, effective date of that amendment the IRS has a more definite guideline to work with than it had previously.
We published a case where a settlement from an emotional injury was exempted from tax. The case we discussed indicated that the victim treated his emotional health as a capital which he uses for his work. Thus, the settlement he received from it is but a return of capital and not an income. The 1996 amendment provided that personal injury recovery amounts excludable for emotional distress are limited to actual out of pocket medical costs in cases of non-physical injuries, such as discrimination, fraud, etc. However, all amounts received on account of a physical injury, with the exception of punitive damages, are excludable under section 104(a)(2), including amounts for emotional distress.