Every year, thousands of emotional distress settlements are given to injured plaintiffs throughout the United States. Once this money is awarded, however, it usually doesn't take long for questions regarding federal taxes to arise.

A frequent question has to do with the taxation of damages awarded for emotional distress. Damages for physical injury or physical sickness are clearly tax-exempt and damages for emotional distress are generally taxable.

However, Code Sec. 104(a) allows the exclusion of damages received for emotional distress to the extent not in excess of the amount paid for medical care related to emotional distress.

Care should be taken in identifying the portion of the damages awarded for emotional distress, especially where the total of the damages includes awards for both physical injury or sickness and emotional distress.

Chief Counsel Memo (CCM) 2009-035 provides a detailed account of IRS's position on how to handle the income and employment tax consequences and reporting duties in connection with employment-related judgments and settlements. In that memo, the Chief Counsel indicates the following:

Sometimes a suit for damages will be settled out of court. When this occurs, and no allocation is specified in the settlement, it is generally necessary to look back at the original suit and prorate (allocate) the settlement according to the original suit.

Care should also be taken with any advice provided by the taxpayer’s attorney. It is not uncommon for them to suggest that emotional distress is tax exempt.