When receiving payments for physical or mental injuries, there is a difference in what's taxable and what's not. According to attorney Robert Wood, of Wood, LLP in San Francisco, payments for physical injury or illness are tax-free but payments from a mental injury or illness are not taxable.
Up until 1996, damages from physical injury were tax-free, says Wood, and that recovery for emotional distress was tax-free as well. After 1996, however, the law changed that the injury has to be physical. Wood says that the question is which comes first - the physical problems or the symptoms of emotional stress? A taxable judge is trying to figure that out in the Julie Blackwood case in Charleston, where a hospital employee was fired and she lapsed into a state of depression which caused other physical problems.
Wood says along with medical records, good language in a settlement agreement are just as important during a tax audit.
A San Francisco-based attorney with Wood, LLP, Robert Wood has written an article on Forbes.com, which can be found here. Robert Wood is also a featured commentator with the Tax Law Channel, providing online, on demand, tax law video content.