A compensatory damages personal injury award, by settlement or judgment, is not taxable under federal law if the case arises out of personal physical injury or sickness. This is true even if the award includes monies for pain and suffering and lost wages.
The support for this view is Section 104 of the Internal Revenue Code. The law is further explained in the 2011 publication, Lawsuits, Awards, and Settlements Audit
Techniques Guide published by the Internal Revenue Service.
Different rules apply for cases arising out of cases other than those involving personal physical injury or sickness. Different rules also apply for punitive damages, even in cases in which punitive damages were awarded involved personal physical injury or sickness. The Internal Revenue Service can examine a personal injury settlement to determine whether it includes a punitive damages award, and has the right to look beyond the paperwork agreed upon between the parties.