Compensatory damages received for a personal physical injury or sickness are excludable from gross income. Damages for any other personal reason, such as defamation, as well punitive damages for any reason, are taxable. In one recent case, a homeowner sued her homeowners association (HOA) for various reasons and received a settlement payment of $70,000 to drop the action. She didn’t report the payment, arguing that it was excludable as damages for personal physical injury (she claimed to have felt sick from conditions in her apartment).
The Tax Court said the settlement was includible in gross income (Denise Celeste McMillan, TC Memo 2019-108). The settlement document described the $70,000 payment as being in consideration of dropping her lawsuit that alleged nuisances, claims of emotional distress, libel, slander, invasion of privacy, and construction defect. There is no language in the settlement document concerning physical injuries or physical sickness. Because the payment was not on account of anything physically wrong with the taxpayer, there was no basis for excluding it from gross income.
The court pointed out that even if the settlement document had been ambiguous, the payment would still be taxable here. When a settlement document isn’t clear, the court looks to the intent of the payor based on facts and circumstances, including the complaint that was filed. The complaint did not mention any specific allegations of physical injury or sickness; general allegations don’t count.