This is an important question because often times the attorney drafting a settlement agreement between parties will be unaware of the tax laws, or what provisions to include or omit in the agreement.
One might think that an agreement that simply denies that any interest whatsoever will be paid would be enough for the plaintiff to avoid interest income.
But this line of reasoning is mistaken. By contrast, interest does not constitute gross income when a settlement states that no interest has been paid (or is sought) and that the payments relate to personal injuries or sickness (such that it is excludable under IRC §104(a)). However, an agreement that appears to simply deny that any interest whatsoever is being paid is not likely to be respected by the taxing authorizes. The solution is to allocate a reasonable but nominal amount to interest.
It is thus critical that the parties to litigation specifically allocate payments in any settlement agreement to avoid payments being reclassified as interest. The exact amount is a facts-and-circumstances determination, best reviewed by a qualified tax attorney.
There is case law supporting this viewpoint. In McShane v. Commissioner, T.C. Memo 1987-151, the language of the settlement agreement specifically provided that payments were to be made without interest. Rather, according to the agreement, the payments were determined solely on basis of the risks that each party faced in continuing litigation. The court respected the allocation set forth in the settlement agreement, noting that the intention of the parties as stated by their attorneys was consistent with the payment of no interest.
By contrast, a post-trial settlement agreement may not be respected by the courts or the IRS if it attempts to explicitly disclaim a court awarded interest. For example, in Rozpad v. Commissioner, 154 F.3d 1 (1998), the taxpayer received a jury award that included prejudgment interest. On appeal, the taxpayers stipulated that none of the settlement amount would include interest. But the court held that the no interest stipulation was ineffective—and that the settlement should include a pro rata share of interest as determined by looking to the original award.