The proper federal tax treatment for any given settlement payment is something of an enigma. Generally, federal courts (and thus, the IRS) respect the terms of a settlement agreement if the terms are clear and the parties expressly allocate the settlement payment or payments to one or more of the underlying claims or causes of action at issue. But, if one or more of these requirements are not present, federal courts are left searching through other evidence in an attempt to determine the payor’s intent, which, absent an express allocation, generally governs the tax characterization of the payment.
The terms of a settlement agreement may become significant in the context of settlement payments received in lieu of damages for personal physical injuries and/or physical sickness. Under Section 104(a)(2) of the Code, these payments are not taxable. However, Section 104(a) specifically provides that settlement payments received in lieu of damages for emotional distress are taxable. So, what is the difference and how can a taxpayer ensure that any settlement payments received are properly treated as non-taxable under Section 104(a)(2)?