Tort lawyers on either side of the “v” typically do not have skills that attract them to tax law. Sure, many of us future tort lawyers took “Federal Income Taxation 203” as we explored the smorgasbord of law school career paths, but most of us did not happily clean our plate and certainly did not return for seconds on tax law.

But tax policy can impact personal injury and wrongful death settlements and judgments. Plaintiffs care about tax consequences of settlements and awards because taxation can impact their net recovery. Defendants care because, other things being equal, a plaintiff who must pay taxes on a recovery will seek a higher settlement amount because of the impact of taxation. Thus, tort lawyers need to know something about income taxes other than the telephone number of their personal tax preparer.

The good news is that under federal tax law, damage recoveries for “personal physical injuries or physical sickness” are not typically considered taxable income by our friends at the Internal Revenue Service (IRS).¹ The reasonable person might say, “OK, I get that. That appears to cover damages for pain and suffering arising out of physical injuries or physical sickness. But what about damages awarded for lost wages? Wage income is taxable income.” Ordinarily, that is true: income owned from one’s labor is taxable under federal law.² But if a settlement or judgment in a personal injury case arising from physical injury or physical sickness includes a past or future earnings claim, the entire settlement or judgment amount (including that attributable to wage loss) is excluded from income.³

If the parties can honestly make the representation, it makes sense for the settlement agreement to include words substantially like these: “the payments referenced herein arise out of ‘personal physical injuries or physical sickness’ under 26 U.S.C. 104(a)(2).” Obviously, such words are not binding on the Internal Revenue Service (as a non-party to the agreement) but they (a) do no harm; and (b) indicate the understanding of the parties as of the date of the settlement.

What about punitive damages? Are they taxable? The answer is “yes,” beyond a shadow of a doubt, even if they are awarded by a judge or jury in a case arising out of physical injuries or physical sickness. Section 104(a)(2) provides, in pertinent part, that “the amount of any damages (other than punitive damages) received … on account of personal physical injuries or physical sickness” need not be included in gross income.⁴ So, while rare as hen’s teeth, payment of punitive damages will result in taxable income.⁵

Interest paid on personal injury judgments is also taxable. As of July 1, 2025, the interest rate on judgments was 9.5% so substantial post-judgment interest may be awarded in cases going through the appellate process.⁶

Note that money received in a personal injury case is excluded from taxation only if it arises out of “physical injury or physical sickness.” What about claims for purely emotional injury such as most claims for negligent infliction of emotional distress, intentional or reckless infliction of emotional distress, defamation, etc.? Are the amounts received by the plaintiff taxable? The answer is, “yes,” if there is no physical injury or sickness arising from the tortious conduct.⁷

Here is how the Internal Revenue Service views the issue:

• Emotional distress itself isn’t a physical injury or physical sickness but damages you receive for emotional distress due to a physical injury or sickness are treated as received for the physical injury or sickness. Don’t include them in your income.
• If the emotional distress is due to a personal injury that isn’t due to a physical injury or sickness (for example, unlawful discrimination or injury to reputation), you must include the damages in your income, except for any damages you receive for medical care due to that emotional distress. Emotional distress includes physical symptoms that result from emotional distress, such as headaches, insomnia and stomach disorders.⁸
• Compensatory damages awarded for wrongful death losses are generally not taxable under federal law because those cases are deemed to have arisen out of “physical injury or physical sickness” and thus any compensatory damage awards are excluded from gross income under Section 104(a)(2). This includes awards for loss of consortium or companionship. Of course, if the wrongful death claim resulted in a punitive damage award, receipt of those funds would create tax liability.
• Structured settlements require the defendant to fund an annuity for the benefit of the plaintiff. The issuer of the annuity makes payments to the plaintiff over time. There is an interest component to the payments. Is some or any part of those payments taxable? No, assuming the parties do the settlement correctly. The Internal Revenue Service taxes neither the principle nor interest section of the annuity payments if the settlement amount arose out of physical injury or physical sickness⁹ and proper form is followed.¹⁰
• Finally, tort awards arising from business disputes will ordinarily result in the collected award being included in gross income. Why? Because the definition of “gross income” is very broad under Section 61 of the Internal Revenue Code and Section 104(a)(2) does not exclude such monies from the definition of gross income.

Occasionally, people try to get imaginative in business tort cases and attempt to avoid federal income tax. One such example is found in Emerson v. Commissioner.¹¹ The first two complaints in a business dispute with the defendant in the underlying case included various business tort claims and claims for intentional infliction of emotional distress and slander. During the mediation of the underlying case, plaintiff added a physical injury claim at the suggestion of an accountant and the judge/mediator, and a second amended complaint containing such allegations was later filed. There was some evidence of physical injury, but the tax court ruled the entire amount of the settlement was taxable, saying:

[W]e cannot hold that the settlement amount or any part of it was paid on account of personal injury. The record compels the conclusion that the reference to personal injuries in the settlement documents was an afterthought, solely in anticipation of tax benefits, and did not reflect the nature of the claim by petitioner against [the defendant in the underlying case]. We therefore hold that the entire settlement amount is includable in petitioners’ gross income.¹²

One disclaimer: tax laws change. And remember you are reading an article on tax law written by a plaintiff’s lawyer. If I were you, I would not be confident that will help you or your client avoid a penalty under 26 U.S. Code § 6662 for an underpayment of taxes. |||

JOHN A. DAY is a plaintiff’s personal injury and wrongful death lawyer with a statewide practice from offices in Brentwood, Murfreesboro and Nashville.  He is the 76th president of the American College of Trial Lawyers. He is not qualified to serve as even a janitor at the American College of Tax Counsel, of which there are only four fellows in Tennessee.

NOTES
1. 26 U.S.C. § 104(a)(2). See also I.R.S. Publication 4345, Catalog Number 38586D (Rev. Nov. 2021), www.irs.gov/pub/irs-pdf/p4345.pdf. Note, however, that if the taxpayer previously deducted medical expenses (for treatment of injuries) that were later recovered in the litigation, the portion of the settlement that is for medical expenses that were deducted in any prior year(s), to the extent those deductions provided a tax benefit, must be allocated as income, and allocated on a pro rata basis across multiple tax years. Lawyers should urge their clients to consult a tax professional on such matters.
2. 26 U.S.C. § 61.
3. Rev. Rul. 85-97, recently cited by the Internal Revenue Service in www.irs.gov/government-entities/tax-implications-of-settlements-and-judgments.
4. (Emphasis added). See also I.R.S. Publication 4345, Catalog Number 38586D (Rev. Nov. 2021), www.irs.gov/pub/irs-pdf/p4345.pdf.
5. There is one interesting exception to this rule. In Alabama, the only damages awarded for wrongful death are punitive damages. Internal Revenue Code Section 104 (c) specifically excludes such awards from gross income.
6. Tennessee’s Administrative Office of the Courts publishes the rate of post-judgment interest every six months, on July 1 and January 1. The rate applied is the rate as of the entry of the judgment and does not fluctuate with later rate changes. For the current rate of post-judgment interest, visit www.tncourts.gov/tennessee-judgment-interest-rates.
7. IRS Publication 525 (2024), Taxable and Nontaxable Income, www.irs.gov/publications/p525#en_US_2024_publink1000229507.
8. Id.
9. IRC § 104(a)(2).
10. The author recommends that a structured settlement professional be engaged to assist in such matters.
11. Emerson v. Internal Revenue Service T.C. Memo. 2003-82 (2003), bit.ly/4aMZ25t.
12. Id. at p. 17.