If you sue for personal physical injuries like a slip and fall or car accident, your damages are tax-free. That may seem odd, since you may be seeking lost wages because you couldn’t work after your injuries. But a specific section of the tax code–Section 104–shields damages for personal physical injuries and physical sickness. Before 1996 “personal” damages were tax-free. That meant emotional distress, defamation and many other legal injuries also produced tax-free recoveries.
But since 1996 your injury must be “physical”. Neither the IRS nor Congress has made clear what that means, but the IRS says your injuries must be visible to be “physical.” This “observable bodily harm” standard generally means that if you sue for intentional infliction of emotional distress, your recovery may be taxed. If you sue your employer for sexual harassment involving rude comments or even fondling, that’s not physical enough for the IRS. Taxpayers routinely argue in U.S. Tax Court that their damages are sufficiently physical to be tax-free; the IRS usually wins these cases.
Even if your injuries are purely emotional, payments for medical expenses are tax-free, and what constitutes “medical expenses” is surprisingly liberal. For example, payments to a psychiatrist or counselor qualify, as do payments to a chiropractor or physical therapist. Many nontraditional treatments count as well.