Although damages paid due to physical injuries are tax-exempt, other payments for non-physical injuries are generally subject to tax. As you might imagine, this issue is often contested in the courts. In the latest example, Zajac, TC Memo 2025-33, 4/16/25, a taxpayer who claimed he was injured while he was being incarcerated walked away with a split decision.
Background: The controlling tax law provision in this area is Section 104(a)(2). Under this tax code section, damages paid for personal physical injury or illness are specifically excluded from federal income tax. For example, if a taxpayer is injured in an auto collision and collects damages or a legal settlement for a back injury, there is no tax on the payment. However, other situations are not as clear cut.
Notably, determining whether damages from emotional distress are taxable or not can be tricky. If the emotional distress relates to a physical injury—like trauma due to chronic pain caused by a car accident—any damages or settlements are usually exempt from tax. Conversely, emotional distress that is not associated with a physical injury—for example, if anxiety is attributable to defamation of character—is generally taxable (other than reimbursements for medical expenses not previously deducted).
Facts of the new case: The taxpayer was arrested in 2005 on charges of domestic assault and battery after his wife alleged to police in a Massachusetts township that he had physically attacked her. He was incarcerated over the weekend.
While in police custody, the taxpayer sought medical attention but did not receive any. When the taxpayer was subsequently arraigned, his wife was unwilling to testify against him and the charges were dropped.
Following this incident, the taxpayer sent a claim letter to the township seeking $100,000 in damages resulting from the arrest and incarceration. He asserted that he suffered physical and emotional injuries as well as violation of various constitutional and state law entitlements, including unlawful seizure of a firearm, suspension of his gun license and an unlawful search of his residence. He alleged that the arresting officer drove recklessly around corners, resulting in him being tossed around in the back seat of the vehicle.
The claim letter advised the township that the taxpayer had preexisting lower back and knee conditions. He asserted that these conditions were aggravated during his arrest and the areas became further inflamed on account of the conditions in the holding cell during his incarceration. In addition, the taxpayer indicated he sustained injuries to his wrists, knees and ankles during the arrest. Finally, the letter stated that the arresting officer acted in a manner to intentionally inflict emotional distress.
The parties eventually settled out of court in 2007. As part of the settlement, the township agreed to pay the taxpayer $35,000. The taxpayer failed to report any part of this settlement as taxable income on his 2007 return. So, the IRS assessed a deficiency.
Taxable or not? The Tax Court split the difference by relying in the “origin of claim” doctrine. Because the claim letter and supporting medical evidence suggested that physical injuries were caused by the arrest, the court treated half of the payment as being excluded from tax. But the other half pertaining to non-physical injuries, including emotional distress, must be reported as taxable income.
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Tags: Income Taxes, Taxes
