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IRC § 104(a)(2) is the federal tax exclusion for compensatory damages received on account of personal physical injuries or physical sickness. It applies whether the recovery comes from a settlement or a judgment. Punitive damages and interest portions are not excluded — they're taxable. Lost-wage components of cases without underlying physical injury are also generally taxable. The structure of the settlement (specifically, how the settlement agreement allocates among damage categories) controls the tax treatment.
What's excluded: compensatory damages for medical care, pain and suffering, loss of consortium, and emotional distress that originates in a physical injury. What's NOT excluded: punitive damages (always taxable), interest (always taxable), employment-discrimination damages without physical injury, and emotional-distress damages where there's no underlying physical harm.
The settlement agreement matters for tax treatment. A lump sum that doesn't allocate among damage categories defaults to the most-taxable interpretation. A well-structured settlement agreement that specifies which portion is for physical injury, which is for lost wages, which is for punitive damages, and so on, gives both sides a defensible position with the IRS.
William Pereira's tax-attorney background means we draft settlement agreements with the tax treatment in mind from the start — not after the check has cleared and the next April 15 is approaching.
This answer is general legal information, not specific legal advice. Pereira & Associates can review your particular facts in the free consultation. Schedule one →
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