IRC Section 104: Taxable and Tax-Free Injury Settlements

Money you receive from a personal injury settlement is generally not taxable when it compensates you for a physical injury or physical sickness. That’s the rule in IRC Section 104(a)(2), which excludes from gross income compensatory damages received “on account of personal physical injuries or physical sickness,” whether the money comes through a court judgment or a negotiated settlement.¹ The phrase “on account of” does the heavy lifting. Every dollar in your recovery is taxable or tax-free depending on whether it traces back to a qualifying physical harm, and the IRS looks at that link closely.

What’s Tax-Free in a Physical Injury Recovery

If your claim is built on a physical injury or physical sickness, the full compensatory amount comes to you tax-free. That covers medical expenses, lost wages, pain and suffering, and loss of consortium, so long as each category flows from the physical harm. Lump sums and periodic payments are treated the same way.¹

Lost wages are the piece that surprises people. Normally wages are taxable, but when lost earnings are bundled into a settlement for physical injuries, the entire recovery, wage portion included, is excludable. The IRS took this position in Revenue Ruling 85-97, holding that a settlement paid on account of personal injuries sustained in an accident is fully excludable, including the amount representing lost wages.² This only works when the wages are part of a physical injury claim. A standalone back-pay claim in an employment case doesn’t get the same treatment.

The IRS applies a “physical” standard with teeth. Courts look for observable bodily harm, such as bruises, broken bones, lacerations, or a diagnosed illness, before treating a claim as one for physical injury.³ The label on the check does not control. A “pain and suffering” payment is tax-free if it comes from a car crash that broke your arm, but fully taxable if it comes from a breach of contract that caused you stress. The controlling question is: what was the settlement intended to replace?²

Emotional Distress Tied to a Physical Injury

Section 104 says outright that emotional distress is not a physical injury or physical sickness on its own.¹ Physical symptoms of emotional distress — insomnia, headaches, stomach problems — do not convert the claim.³

But when emotional distress flows from an actual physical injury (you were in a crash, suffered a spinal injury, and developed PTSD as a result), damages for the emotional component are excludable because they trace to the bodily harm.² And even when emotional distress stands alone, the portion of damages that reimburses medical expenses you paid to treat it (therapy, medication, psychiatric care) can be excluded, provided you didn’t already deduct those costs.¹

What’s Taxable Even in a Physical Injury Case

Punitive Damages

Punitive damages punish conduct rather than compensate loss, and Section 104(a)(2) carves them out of the exclusion.¹ Even when they arise from a case involving severe physical injuries, you report them as other income.⁴ A narrow exception in Section 104(c) preserves the exclusion for punitive damages in certain wrongful death actions, but only where state law as it stood on or before September 13, 1995, permitted only punitive damages in wrongful death cases. Very few states qualified, so the exception rarely applies in practice.

Interest on the Judgment or Settlement

Any interest that accrues on a judgment or settlement is taxable as interest income, regardless of the underlying claim.⁴ Pre-judgment and post-judgment interest are both ordinary income. In cases that drag on for years, the interest can be significant, and people are sometimes caught off guard to find a tax bill attached to what they assumed was a tax-free recovery.

Reimbursement of Medical Expenses You Already Deducted

Section 104(a) contains a clawback. If you itemized a deduction for medical expenses in a prior year and a later settlement reimburses those same expenses, you have to include the reimbursed amount in gross income.¹ You already got a tax benefit from the deduction, and the rule prevents a second tax-free bite. Under the tax benefit rule in IRC Section 111, the amount you have to include is limited to the tax savings the earlier deduction actually produced.⁵

When the Claim Isn’t Physical

Settlements for defamation, discrimination, breach of contract, and similar non-physical claims are generally taxable as ordinary income.² These payments aren’t subject to Social Security and Medicare taxes, but they go into gross income. The same applies to a standalone emotional distress claim with no underlying physical injury: the portion for the distress itself is taxable, though the part reimbursing unreimbursed medical costs to treat the distress can still be excluded.

The Attorney Fee Trap

This is where taxable settlements bite hardest. If your recovery is taxable, you’re taxed on the full gross amount, including the share your attorney takes as a contingency fee. The Supreme Court settled this in Commissioner v. Banks, treating the attorney as the client’s agent so that the fee is income to the client even when the check goes straight to the lawyer.⁶

Whether you can deduct the fee depends on the claim. For employment discrimination, civil rights, and certain whistleblower cases, IRC Section 62(a)(20) and (a)(21) allow an above-the-line deduction for attorney fees and court costs, so you’re effectively taxed on your net recovery. The deduction can’t exceed the income you included from the claim.⁷ For other taxable claims like breach of contract or business torts, the attorney fee deduction sits in the miscellaneous itemized deduction category that the Tax Cuts and Jobs Act suspended through the end of 2025. It is scheduled to return for 2026, though Congress could extend the suspension.

None of this hits a physical injury recovery. Because the damages themselves are excluded, the attorney fee is paid from tax-free money and never enters gross income in the first place.

How Settlement Language Changes the Answer

The way an agreement allocates the payment matters. The IRS looks at the facts and circumstances surrounding each payment and asks what it was meant to replace.² A clear tax characterization inside the agreement supports an exclusion, and the IRS is generally reluctant to override the stated intent of both parties.

If the agreement is silent, the IRS looks to the payor’s intent. That is a bad position for you, because a defendant or insurer has no reason to route dollars toward your tax-free categories. Before signing, negotiate the allocation. When a case mixes physical injury claims with other claims, assigning specific dollar figures to specific claim types gives you the strongest ground if the IRS questions the return. Vague catch-all language like “full and final settlement of all claims” leaves room for recharacterization. Specificity protects you: name the physical injury, describe the compensatory categories, and put dollar amounts next to each.

Workers’ Comp and Insurance Benefits

Payments received under a workers’ compensation act are excluded from gross income under Section 104(a)(1).¹ The statute has to function as a workers’ compensation law and cover injuries or sickness incurred in the course of employment. Payments for non-occupational injuries don’t qualify, and amounts above what the applicable law authorizes fall outside the exclusion. A retirement pension triggered by a workplace injury is also outside the break if it’s calculated on age, length of service, or prior contributions rather than the injury itself.⁸

Accident and health insurance benefits under Section 104(a)(3) are tax-free when you paid the premiums yourself with after-tax dollars.¹ With employer-provided coverage, Section 105(a) pulls the benefits into income to the extent they trace to employer contributions that weren’t taxed as part of your wages.⁹ Most employer health plans use pre-tax dollars, so employer-paid disability income is typically taxable. If your employer provides the policy but includes the premium in your taxable wages, the benefits come out tax-free.

Structured Settlements

For a large physical injury recovery, you may have the option to take periodic payments through a structured settlement instead of a lump sum. Section 104(a)(2) excludes the periodic payments the same way it excludes a lump sum.¹ The advantage runs further: investment returns earned inside the annuity that funds the structure also come out tax-free as part of the periodic payments. Take a lump sum instead, invest it, and any interest or growth you earn is taxable.

IRC Section 130 governs the assignment mechanics and requires that the payments be fixed in amount and timing, with no ability for the recipient to accelerate, defer, or change them.¹⁰ That inflexibility is the tradeoff for the tax-free growth.

For a taxable settlement, a structure doesn’t eliminate the tax; it defers it. Each payment is taxed when received, but spreading the income out can keep you in a lower bracket.

How the Payment Gets Reported

Even a fully tax-free settlement can produce IRS forms. Defendants and insurers must issue a Form 1099-MISC for reportable payments of $600 or more. Taxable damages, including punitive damages and non-physical injury compensation, go in Box 3. Payments made to your attorney are separately reported in Box 10 as gross proceeds paid to an attorney.¹¹

Damages received on account of physical injury or physical sickness generally don’t need to be reported on a 1099 by the payor. If any portion of your physical injury settlement reimburses medical expenses you previously deducted, that portion is taxable and belongs on Schedule 1 of Form 1040 as other income.⁴ Interest goes on the return as interest income. Punitive damages go on Schedule 1 as other income.

If you receive a 1099 for a settlement you believe is fully excludable under Section 104, don’t just leave it off. Report the amount on your return and then exclude it, so the IRS can match the 1099 to your filing without kicking out an automated notice.

1
Office of the Law Revision Counsel. 26 USC 104 Compensation for Injuries or Sickness
2
Internal Revenue Service. Tax Implications of Settlements and Judgments
3
Internal Revenue Service. Private Letter Ruling 200041022
4
Internal Revenue Service. Publication 4345 – Settlements – Taxability
5
Office of the Law Revision Counsel. 26 US Code 111 – Recovery of Tax Benefit Items
6
Justia US Supreme Court. Commissioner v. Banks, 543 US 426 (2005)
7
Office of the Law Revision Counsel. 26 USC 62 Adjusted Gross Income Defined
8
eCFR. 26 CFR 1.104-1 – Compensation for Injuries or Sickness
9
Office of the Law Revision Counsel. 26 USC 105 Amounts Received Under Accident and Health Plans
10
Office of the Law Revision Counsel. 26 US Code 130 – Certain Personal Injury Liability Assignments
11
Internal Revenue Service. Instructions for Forms 1099-MISC and 1099-NEC