Can I Exclude a Settlement from a Personal Injury Lawsuit?

Yes — compensatory damages for physical injuries or illness are generally excluded from taxable income under Section 104. This includes payments for medical expenses, pain and suffering, and lost wages arising from a physical injury. However, punitive damages are always taxable regardless of whether the underlying injury was physical. Emotional distress damages are taxable unless they stem directly from a physical injury. Settlement proceeds that compensate for lost profits, breach of contract, or employment discrimination (without a physical injury claim) are generally taxable. When you settle a lawsuit, the allocation of the settlement between taxable and non-taxable categories matters — document it carefully.