IRC Section 104(a)(2): Are Injury Settlements Taxable?

Receiving a settlement for an injury can provide financial relief, but it also introduces tax considerations. Under Internal Revenue Code (IRC) Section 104, an exclusion allows individuals to avoid paying taxes on certain awards. This rule permits a person to exclude payments from their gross income if they are for personal physical injuries or sickness. The purpose of this provision is to make the injured party whole again without diminishing their award through taxation. This tax-free treatment is not automatic and applies only when specific criteria are met.

Qualifying for the Tax Exclusion

The main factor in determining if settlement proceeds are tax-free is the “origin of the claim” test. To qualify for the tax exclusion, the payment must be for damages received on account of personal physical injuries or sickness. This means the reason for the lawsuit and the resulting payment must be a physical harm to the body. The IRS requires evidence of observable bodily harm, such as injuries from a car accident, a slip-and-fall incident, or medical malpractice.

Compensation for emotional distress is excludable from income only if the distress is a direct consequence of a physical injury. For example, if an individual suffers from anxiety resulting from the trauma of an assault, the compensation for that emotional suffering is not taxed. In contrast, if a settlement is for emotional distress from a non-physical event, such as employment discrimination or defamation, those funds are considered taxable income. The physical injury must be the root cause for the exclusion to apply.

Compensation for lost wages can also be excluded from gross income. According to the IRS, if an individual is unable to work due to a qualifying physical injury or sickness, the portion of the settlement that replaces those lost wages is not taxable. The key is that the wages were lost “on account of” the physical injury, restoring the individual to the financial position they would have been in otherwise. In contrast, if a settlement awards back pay for a non-physical claim, such as a discrimination lawsuit without an accompanying physical injury, that amount is fully taxable as income.

What Settlement Proceeds Are Taxable

Even when a settlement originates from a physical injury, certain portions of the award can be subject to taxation. The IRS reviews the different components of a settlement to determine their tax treatment based on their purpose.

Punitive Damages

Punitive damages are almost always considered taxable income. Unlike compensatory damages that reimburse a victim for losses, punitive damages are intended to punish the defendant for egregious conduct and deter future wrongdoing. Because these payments go beyond making the victim whole, the IRS does not view them as compensation for an injury. The tax exclusion does not apply to punitive damages, and they must be reported as “Other Income” on a tax return.

Interest

Any interest paid on a settlement award is taxable. Interest can accumulate on a judgment between the time of the verdict and payment (post-judgment interest) or be included as part of the settlement itself (pre-judgment interest). This amount is not considered compensation for the physical injury. The IRS treats it as taxable interest income, representing payment for the time the defendant held the funds before paying the claimant.

Reimbursement for Previously Deducted Medical Expenses

The taxability of reimbursements for medical costs is governed by the “tax benefit rule.” If an individual previously deducted medical expenses related to their injury on a tax return, any settlement money received as reimbursement for those costs is taxable income. This is because the taxpayer already received a tax benefit from the deduction. If no deduction was taken for the medical expenses, then the reimbursement portion of the settlement is not taxable.

Confidentiality Clauses

In some settlement agreements, a portion of the payment may be allocated to a confidentiality or non-disclosure clause. The IRS views this payment not as compensation for the injury, but as payment for the service of remaining silent. Consequently, any funds designated for agreeing to confidentiality are considered taxable income and must be reported.

The Importance of the Settlement Agreement

The settlement agreement is the primary evidence the IRS uses to determine the tax consequences of the funds received. The language and terms within this document create the official record of what the payment was intended to replace. The IRS gives significant weight to the written intent expressed in the agreement, so a well-drafted agreement provides a clear justification for the tax treatment of the funds, while a vague one can invite scrutiny.

A key element is the allocation of damages, which breaks down the total settlement into distinct categories. For example, an agreement might explicitly state that a $500,000 payment is allocated as $300,000 for physical injuries, $100,000 for lost wages, and $100,000 for taxable punitive damages. This separation provides a strong basis for excluding compensatory portions from income. Without a specific allocation, the entire settlement could be at risk of being reclassified by the IRS, potentially leading to a larger portion of the award being deemed taxable.