When Are Damage Awards Taxable?

Sometimes the Internal Revenue Code has a heart. While the law makes clear that income is taxable from whatever source derived both legal and illegal, Congress in its wisdom created some specific exclusions. It really seems unfair to tax someone who was had physical injuries and receives a legal settlement for them. Those payments are designed to render the injured plaintiff whole again. The thinking may be also that physical injury is preventing them from returning to work. Every year there are numerous tax cases trying to determine whether or not physical injury is involved.  While the code goes easy on physical injury it makes payments for emotional distress taxable. The wisdom here may be a little cloudy but the tax law is not. Of course things can be muddy when one award is made for both physical and emotional injuries or when there is a connection between them. Consider the case of Barbato, TC memo 2016 – 23. In that case a woman suffered actual physical injuries. But the lawsuit that was brought on her behalf claimed that her employer had discriminated against her because she had requested medical accommodation for a prior workplace injury. So the question became was the award for the discrimination sufficiently connected to the physical injury to be excludable? The Tax Court refused to make the connection and held that the payments for the emotional distress were taxable. Litigation lawyers are wise to pay close attention to what they are suing for and alleging in any complaint or petition filed on behalf of their clients as it may dictate the extent that the proceeds will be taxable.