Determining what income is taxable and what is not taxable is often difficult. But the tax code is specific and tries to clarify these issues. One common question people often have is whether insurance proceeds are taxable.
The Internal Revenue Service classifies "compensatory damages" as income you receive for a physical injury as "other compensation" and generally holds that these forms of reimbursement are not taxable. Specifically IRS Publication 525 "Taxable and Nontaxable Income" states "Many other amounts you receive as compensation for sickness or injury are not taxable."
One type of "other compensation" that is specifically listed as not taxable is: "Compensatory damages you receive for physical injury or physical sickness" and it doesn't matter whether they are paid in a lump sum or over a series of payments.
Accident or Health Insurance Proceeds
The section on "other compensation" specifically mentions "benefits you receive under an accident or health insurance policy" as not taxable and it doesn't matter if you paid the premiums on the policy that is paying out or if the premiums were paid by your employer as long as you originally reported the premiums as income.
The IRS even considers disability benefits under insurance policies and compensation for dismemberment as nontaxable as long as it is based on the injury and not on periods of absence from work.
Even if your payment was based on "emotional distress" due to an injury, it is not taxable. If, however, it was for "emotional distress" due to something other than a physical injury, the income may be taxable.