Pain and suffering settlements aren't taxable under federal or state law, states Nolo. Damages for pain and suffering are considered compensatory damages, which the IRS deems non-taxable. Compensatory damages are meant to compensate the victim for direct losses, such as lost wages, medical bills, loss of consortium and attorney's fees.
Nolo recommends separating the award in a personal injury case into compensatory damages and punitive damages. Punitive damages are taxable. If the damages are not separated, the IRS could make the argument that the entire award was punitive damages and could require taxes be paid on the compensatory damages as well. Plaintiff's lawyers typically ask for this separation.
Damages related to breach of contract are also taxable. For example, if a plaintiff brings a claim that he was negligently exposed to a germ through a breach of contract, his damages are taxable. Conversely, if he brings the claim that he was negligently exposed to germs as a personal injury suit and was awarded compensatory damages, the damages are not taxable. Emotional distress awards are always taxable. Nolo recommends that plaintiffs have as much of their award as possible classified as compensatory damages. The IRS has the right to challenge any award classification.