The general rule is all items received constitute “gross income” and are taxed. However, IRC §104(a)(2) provides an important exception to this rule. Section 104(a)(2) provides a broad exclusion from gross income for non-punitive damages received “(whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness.” In other words, one need not pay taxes on certain awards received as a result of his/her personal physical injury.
Unfortunately, neither the Code nor Treasury Regulations offer much guidance as to the meaning of “physical.” However, the IRS in a letter ruling stated that “we believe that direct unwanted or uninvited physical contacts resulting in observable bodily harms such as bruises, cuts, swelling, and bleeding are personal physical injuries.” PLR 200041022.
Furthermore, the legislative history of Section 104 makes clear that emotional distress and any attendant symptoms do not constitute a physical injury or physical sickness—unless the income payments are received as a result of emotional distress stemming directly from a physical injury or physical sickness.
For example, in Letter Ruling 200041022, the taxpayer was physically and sexually assaulted by her employer, resulting in observable bodily harm. The taxpayer filed suit alleging among other things intentional infliction of emotional distress. Under these facts, the IRS concluded that the damages received for emotional distress were excludable under Section 104(a)(2), because they were directly attributable to a personal physical injury where there was observable bodily harm.
Courts have also been notoriously capricious in determining when damages are deemed to be received “on account” of a personal physical injury or sickness when the personal physical injury or sickness is but one link in a chain of events leading to the plaintiff’s cause of action. Therefore, in order for a payment to qualify for exclusion under Section 104(a)(2), it is critical that plaintiffs establish that settlement payments were received on account of a personal physical injury or sickness to the greatest extent possible.