In terms of settlement and judgments, the most important exception to the general income inclusion provision (IRC §61) is for personal physical injuries and physical sickness under Section 104. Section 104 identifies 5 areas of exclusion: 1) benefits under workmen’s compensation acts; 2) damages on account of personal physical injury or physical sickness; 3) benefits under self-financed health and accident insurance policies; 4) disability pensions arising out of certain government service; and 5) disability income received by officials who are violently attacked outside the country. One justification sometimes offered for these exclusions are that a personal damage award makes a taxpayer whole and puts him in the same position he would have been in had the injury not occurred. Although the better explanation may be compassion—the individual has suffered enough. Currently, damages received on account of non-physical injury or sickness (i.e. defamation, age discrimination, housing discrimination, injury to personal or business reputation, etc.) are not excludable from gross income. However, damages for non-physical injury or sickness that are “on account of” physical injury or sickness are excludable.
