This is the second in a series of articles on issues surrounding the Taxation of Settlements and Verdicts. This article addresses the amounts that can be excluded from gross income.

Amounts Excluded. Internal Revenue Code Section 104(a)(2) excludes from gross income compensatory damages:

1. Received through prosecution of a legal suit or action or through a settlement agreement entered into in lieu of such prosecution,2. Based on tort or tort-type rights, and 3. Paid on account of physical personal injuries or sickness.Amounts Not Excluded. IRC Section 104 does not apply to punitive damages, except as allowed by Section 104 (c), amounts received as reimbursements for medical expenses previously deducted under Code Section 213, Rev. Rul. 79-247, or payments to businesses.

Amounts Must be Received on Account of Physical Injury. Even if damages are paid as a result of tort or tort-type actions, they must also be received on account of physical personal injuries or sickness to be excluded from a recipient’s gross income.

Damages that Flow from Physical Injury. If a claim has its origin in a physical personal injury or sickness, then all compensatory damages that flow from that injury or sickness are payments received on account of physical personal injury or sickness.

Damages that Flow from Emotional Distress. IRC Section 104(a) specifically excludes emotional distress from the definition of physical injury or physical sickness, except where damages are paid for medical care attributable to such distress. This effectively eliminates the exclusion of payments arising out of claims for discrimination, breach of a fiduciary duty, malicious prosecution, defamation, wrongful discharge, intentional or negligent infliction of emotional distress. 

Physical Injuries that Flow from Emotional Distress. Damages for physical illnesses arising from emotional distress (e.g., insomnia, headaches, stomach disorders) are generally not excludable because they are considered mere symptoms of the underlying distress. The emotional distress resulting from the tort is not treated as a physical personal injury or sickness.

Emotional Distress Flowing from Physical Injury. Damages for emotional distress resulting from a physical injury are excluded from gross income. See Letter Ruling 200041022 distinguishing damages relating to physical injury from damages without physical injury.