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J.K. Lasser's Your Income Tax 2013: For Preparing Your 2012 Tax Return by J.K. Lasser Institute

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11.7 How Legal Damages Are Taxed

By statute, compensatory damages for physical injury or physical sickness are tax free, whether fixed by a court or in a negotiated settlement. Damages for nonphysical personal injuries, such as for discrimination, back pay, or injury to reputation, are taxable; a limited exception for certain emotional distress damages may be available as discussed below. Damages for lost profits, breach of contract, or interference with business operations are taxable. Interest added to an award is taxable, even if the award is tax-free damages for physical injury.

Emotional distress.

The law that provides an exclusion for damages received on account of a physical illness or sickness specifically provides that emotional distress by itself is not treated as a physical injury or sickness. To be tax free, damages for emotional distress must be attributable to a physical injury or sickness. For example, if you are injured in an accident and receive damages for emotional distress, or damages for emotional distress are included in the damages received in a wrongful death action, the emotional distress damages are tax free because they are deemed to be received “on account of” a physical injury; see Example 1 below.

If emotional distress damages are due to an injury other than a physical injury or sickness, as in a discrimination action, the damages are taxable with one exception: Damages up to the amount of actual medical care expenses attributable to emotional distress ...

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