Tax liability?-out of court settlement-HELP!!!?

My wife recently received an out of court settlement for 123,000 from her ex-employer. It is listed in the agreement as compensation for pain and suffering, and no taxes were withheld. She was physically threatened on the job by a co-worker who lunged at her and actually chased her out of a company building. After one year of long term disability and workers comp, she was seperated from the company. She was given a disability pension from the company, is now receiving social security disability, and continues to receive workers comp. She is diagnosed and suffers from Post traumatic stress syndrome, is on 3 types of medication, and continues seeing her psychiatrist and psychologist regulary. This was not an injury like a broken leg, but the emotional injury from PTSS is a manifestation of the attack, which occurred on the job. So the question us- is this type of cash settlement taxable? Our attorny fees were paid directly to our lawyer, he indicates that part for sure is no longer taxed

Settlements are tax free for physical injury.
Emotional distress is not considered physical injury.

I would expect your wife to receive a 1099-Misc for the $123,000. If so, it's other income and the lawyer fees go on schedule a as an itemized deduction (on the 1040 you get to deduct them if they are part of taxable income).

IRS publication 525.

It doesn't seem fair, but here is the law: Even if damages are paid as a result of tort or tort-type actions, under currently applicable law, in order to be excluded from a recipient's gross income they must also be received on account of physical personal injuries or sickness.

OBSERVATION: Prior to August 21, 1996, there was no express requirement that a personal injury or sickness be a physical one. Thus, for damages received before that date, courts may permit the exclusion of damages received in cases involving non-physical personal injuries, such as defamation or discrimination, and non-physical illnesses, such as emotional distress. For a discussion of amounts received on account of non-physical injuries and illnesses under prior law, see Section 18.2(i).

An award of front and back pay to a taxpayer in a lawsuit under the Americans with Disabilities Act was not excludable from the taxpayer's income because the award was not made on account of physical injuries, but rather was made on account of discrimination based on physical injuries. 43 The IRS has also ruled that exemplary damages awarded in a wrongful death action are not damages received on account of physical injuries or physical sickness, so they are not excluded from income. TAM 200243021.

Emotional distress resulting from the tort is not treated as a physical personal injury or sickness. Thus, for example, the exclusion from gross income does not apply to damages received through employment discrimination or defamation actions accompanied by a claim solely for emotional distress. However, taxpayers can exclude damages received (1) pursuant to a wrongful death action or (2) for medical expenses associated with emotional illness (to the extent they do not exceed actual expenses).

EXAMPLE: Sue suffers from depression stemming from alleged employment discrimination and, as a result, is treated by a psychiatrist and takes prescription antidepressants. In a bargained-for and arm's length settlement of her claim, Sue's employer pays her a sum that, under the settlement agreement, is allocated between an amount compensating her for her emotional distress and an amount reimbursing her for her medical expenses for psychiatric counseling and prescription drugs. The portion received in reimbursement of her medical expenses is excluded from her gross income, but the portion received in compensation for her emotional illness is included in her gross income.

I think the best you can hope for is that amounts reimbursing you for medical expenses will not be taxable.

Jim Kirby, CPA/PFS, CFP, CFS