In most cases, monetary damages awarded by a court of law in the United States are treated as taxable income, with the exception of awards for physical injury or physical sickness. According to Nolo, these exceptions are explained in code 26 U.S.C. § 104(a). Other monetary awards arising from law settlements are taxed at ordinary rates.
Even when awards are for physical injury or illness, they can still be taxable if they are awarded as punitive damages. Nolo explains that these are awards intended to punish the defendant. Anyone receiving damages should be aware that lump sum payments intended to compensate for money that should have been paid by the defendant may bump the taxpayer who wins the lawsuit into a higher tax bracket.
Forbes points out that damages for emotional distress are not tax-free, although there are exceptions. If the emotional distress is triggered by physical injury, then taxes may not be due. Ordinarily, however, the IRS wants to see "observable bodily harm." Forbes cautions that the rules are full of nuances and exceptions.
Cornell University Law School notes that code 26 U.S.C. § 104(a) also allows tax exemption for personal injury and sickness income received from other sources. In addition to court settlements, the income can come from, among other things, a pension, annuity or similar allowance for injury and illness resulting from active service in the armed forces.