Tax laws can be confusing, and the answer is almost always “It depends.”
Let’s say you filed a case alleging that you suffered a traumatic brain injury. Did you settle out of court? Were you awarded damages after a trial, or by the judge? In all cases, it’s possible that you have to pay taxes. This is because recovered damages are taxed according to their origin. The tax on a settlement for wrongful termination is different from the tax on a settlement for a personal injury lawsuit.
In general, compensatory damages are not taxable. This applies to both the federal government and your state. Compensatory damages can include lost wages, the cost of doctor’s visits, medication, etc.
On the other hand, punitive damages, which can include emotional distress, are taxable. You should report the amount to the IRS as “Other Income”. Even if you received the punitive damages in a settlement for personal injury, the amount is still taxable.
If this seems simple, you should know that there are a lot of special cases and exceptions. Let’s say you went to a psychiatrist or a therapist to recover from the accident. This means that damage in this instance was purely emotional. Even so, the payment to the specialist is still considered a medical expense. The part of the settlement earmarked for your therapist is not taxable.
It would probably be best to consult with a tax attorney before resolving a case. You can prevent a lot of future tax-related trouble by considering the language of a settlement agreement before it becomes an issue.