Tax Court: Emotional Distress Settlement Still Counts as Taxable Income!

For federal tax purposes, proceeds from legal settlements are generally included in taxable income unless specifically excluded by law, such as those for personal physical injuries or sickness. One taxpayer received $135,000 from her former employer to resolve claims of sexual harassment and discrimination. She didn’t report it on her tax return. After receiving an IRS Notice of Deficiency, she argued the payment wasn’t taxable. But the U.S. Tax Court disagreed, finding that the settlement clearly compensated her for “alleged emotional distress, anxiety and humiliation,” not for physical injuries. Accordingly, the amount was taxable income. (TC Memo 2025-101)