Tax Code 104: Injury and Sickness Compensation Rules

Internal Revenue Code Section 104 provides an exclusion from gross income, meaning funds from personal physical injuries or sickness are generally not subject to federal income tax. This is an exception to the broader rule in Section 61, which defines gross income as all income unless explicitly exempted. The principle is that such payments compensate for a loss rather than generate gain. Understanding this function helps in correctly determining which amounts are tax-free and which must be reported to the IRS.

Types of Excludable Compensation

Workers’ Compensation

Payments received under a workers’ compensation act for a work-related sickness or injury are exempt from federal income tax. This exclusion applies to benefits that compensate for lost wages or medical expenses, and it extends to payments made to a survivor in a work-related death. These payments are not reported as income. However, if an employee returns to a light-duty role, payments for that work are taxable wages. The key is that the payment must be made specifically under a workers’ compensation law to qualify for the exclusion.

Damages from Lawsuits and Settlements

Money received from a lawsuit or settlement for personal physical injuries or sickness is excludable from gross income, whether paid as a lump sum or in installments. The exclusion covers compensatory damages for pain and suffering, medical expenses, and loss of consortium directly resulting from a physical injury. The payment must be made “on account of” the physical injury or sickness, requiring a direct link between the two. The law specifies that the injury must be physical, making this distinction a central point of analysis.

Accident or Health Insurance Proceeds

Proceeds from an accident or health insurance policy are tax-free if you paid the premiums with after-tax money. This rule allows individuals who fund their own coverage to receive benefits without tax liability, and it applies to payments that reimburse for medical expenses as well as to other benefits paid out under the policy terms. If an employer pays for the plan and those contributions are not included in your gross income, then any benefits you receive are taxable. When both parties contribute, benefits must be allocated between taxable and nontaxable portions based on the proportion of premiums paid.

Certain Disability Pensions

A narrow exclusion exists for specific disability-related pensions. This rule applies to amounts received for personal injuries or sickness resulting from active service in the armed forces of any country, the Public Health Service, or the Coast and Geodetic Survey. These benefits for service-connected disabilities are not taxed. This provision is highly specific and should not be confused with most private disability pensions, which are taxable as they are considered a replacement for wages. The excludability is tied directly to the governmental or military nature of the service and the resulting injury.

Qualified Disaster Relief Payments

Under Internal Revenue Code Section 139, payments an individual receives as a result of a qualified disaster are not included in gross income. These payments are tax-free if they reimburse reasonable personal, family, living, or funeral expenses incurred from the disaster, including payments for medical or dental expenses related to an injury from the event. These payments are not subject to income, self-employment, or employment taxes. This provision ensures that individuals receiving aid to recover from major disasters do not face an additional tax burden on their assistance.

Critical Distinctions and Limitations

Physical vs. Nonphysical Injuries

The tax exclusion for damages is strictly limited to payments for “personal physical injuries or physical sickness,” meaning there must be observable bodily harm. Compensation for purely nonphysical injuries, such as emotional distress or defamation, is considered taxable income. An exception exists when nonphysical injuries directly result from a physical one. If a settlement compensates for a broken arm and the associated emotional trauma, the entire amount may be tax-free, but proceeds from a lawsuit for emotional distress alone are taxable.

Compensatory vs. Punitive Damages

The tax treatment of legal awards also depends on the type of damages. Compensatory damages reimburse a person for actual losses, such as medical bills or pain and suffering, and are tax-free if they stem from a physical injury. In contrast, punitive damages are meant to punish the wrongdoer. Punitive damages are taxable income, even if they arise from a physical injury case, as the IRS views them as a financial windfall rather than a restoration of a loss.

Allocating Settlement Proceeds

The language within a settlement agreement helps determine how the proceeds are taxed. When a settlement resolves multiple claims, such as for physical injuries and punitive damages, the agreement should clearly allocate funds among these categories. A specific allocation provides a strong basis for excluding the portion related to physical injuries. If a settlement agreement is silent on the allocation, the IRS may look to the payor’s intent or challenge the taxpayer’s classification of the funds. An unallocated lump-sum payment creates ambiguity and increases the risk that the entire amount could be deemed taxable.

Treatment of Lost Wages

Payments that replace lost income are normally taxable. However, an exception applies if damages for lost wages are received as part of a settlement or award for personal physical injuries. In this case, those amounts can be excluded from gross income. If the lawsuit is fundamentally about compensating for a physical injury, any damages, including those calculated based on lost wages, are tax-free. Conversely, a settlement for lost wages due to a nonphysical event like unlawful termination is taxable income and subject to employment taxes.

Tax Reporting and Recordkeeping

Handling Tax Forms

When receiving a settlement, you might receive an information return from the paying party, such as Form 1099-MISC. Taxable proceeds, like punitive damages or damages for nonphysical injuries, are reported in Box 3, “Other income.” The tax-free portion of a settlement for physical injuries should not be reported on a Form 1099. You may also receive Form 1099-INT for any interest paid on a settlement amount, which is always taxable. Carefully reviewing any tax forms received is necessary to distinguish between the taxable and nontaxable components.

Reporting on Form 1040

The reporting of settlement proceeds on a tax return depends on their taxability. The excludable portion of a settlement for physical injuries is not reported on Form 1040 or its schedules; this income is tax-exempt and simply omitted from the return. Taxable amounts must be reported correctly. Interest income from a Form 1099-INT is reported on Schedule B, while taxable damages from a Form 1099-MISC are reported on Schedule 1 (Form 1040) as “Other income.” Properly segregating and reporting only the taxable portions ensures compliance.

Essential Documentation

Maintaining thorough records is necessary for anyone who has received compensation for an injury or sickness. In the event of an IRS inquiry or audit, the taxpayer must be able to substantiate the basis for excluding the income. These records collectively form the evidence needed to support the tax-free treatment of the received funds. Key documents to retain include:

• The final, signed settlement agreement or court judgment, which should ideally specify the allocation of funds.
• Correspondence from legal counsel that clarifies the nature of the damages.
• Medical records, doctor’s notes, and billing statements to prove the existence and extent of the physical injury or sickness.
• A copy of that policy and proof of premium payments if the compensation came from an insurance policy.