The tax treatment of personal injury settlements and verdicts is widely misunderstood, but the rule is actually simple. All compensatory damages attributable to a physical injury or sickness (e.g., broken bone, cut, bruise, medical malpractice or wrongful death) received pursuant to a settlement or verdict are tax free. Punitive damages are always taxable.

For example, if a plaintiff suffers a broken bone in an accident, and the case is settled or a verdict awards the plaintiff itemized damages for pain and suffering, medical expenses, lost wages and emotional distress, and awards the plaintiff's spouse damages for loss of services, then all such damages are tax free. They are now, and always have been, tax free. The U.S. Supreme Court, Congress, and the IRS agree on this tax treatment.

There is a common misconception that damages for lost wages and emotional distress are always taxable, but they are treated the same as all other compensatory damages: They are tax free if attributable to a physical injury or sickness.