• The IRS treats most lawsuit awards as taxable income.tax forms image by Chad McDermott from Fotolia.com
  
  The Internal Revenue Service taxes all income unless specifically excluded by the Internal Revenue Code. This includes income derived from lawsuit awards. The IRS taxes lawsuit awards as gross income in most cases, including punitive damages and awards based on the court's interpretation of an underlying contract. However, if the settlement award is compensation for physical injuries or sickness, then the award is generally not taxable.
  
  

Physical Injury or Personal Sickness Awards

• Actual damage awards resulting from wrongful or tortuous physical injury are excluded from income under Internal Revenue Code Section 104(a)(2), regardless of whether the damages are paid as a lump-sum payment or monthly installments.
  
  

Emotional Distress Awards

• A court may award emotional distress compensation for a physical injury or for the sole injury of emotional distress. Damages from emotional distress claims resulting from a physical tort or injury are not taxable. However, the IRS taxes emotional distress claims resulting from non-physical injuries as ordinary income. For instance, an emotional distress award for various stomach ailments, such as stress-related peptic ulcers, may be taken tax-free. On the other hand, emotional damages suffered as a result of employment discrimination are included as income.
  
  

Wrongful Death Settlement Awards

• Claims for wrongful death may result in a settlement payment to the decedent's estate. Amounts awarded to compensate the decedent's estate for personal injuries are excludable and considered non-taxable. However, punitive damage awards are taxed as gross income.
  
  

Product Liability Awards

• Product liability awards may be based upon physical and mental injuries. For instance, a taxpayer may sue a manufacturer for faulty chairs. Customers who subsequently purchased the defective chairs from the taxpayer's company may file a claim with the local business bureau for defective products and misleading claims. These allegations may lead to the taxpayer suffering lost profits. The award for loss or damage to business reputation is treated as ordinary income. However, awards from customers that allege physical damages due to defective products are physical injury awards.
  
  

Unlawful Discrimination Awards

• Discrimination lawsuits are brought to enforce civil and constitutional rights based upon religion, sex, race or disability. The costs expended to cover attorneys' fees and incidental court fees and court costs the attorney charges the taxpayer are deductible.
  
  

Interest, Compensation for Lost Wages and Profits

• The portion of the award that is used as an interest payment is included as ordinary income. The compensation for lost profits and lost wages are typically based upon an underlying contractual agreement that allows for compensation of the taxpayer's lost profits as a result of breaching an agreement or failure to mitigate damages. Interference with business relationships, also called "tortuous interference," must be included as ordinary income.