Hopefully you ll never need to know how payments for personal injuries are taxed. But here s the story, just in case you or a loved one does need to know.

Payments for Physical Injury or Sickness Are Tax-Free

Payments received as compensation for physical injury or physical sickness are federal-income-tax-free. It doesn t matter if the compensation is from a court-ordered award or an out-of-court settlement, and it makes no difference if it is paid in a lump sum or installments. Compensation for emotional distress that arises from physical injury or sickness is also tax-free, because the distress is considered part and parcel of the physical injury or sickness.

Amounts received for medical expenses are tax-free, too. However, if you claim a medical expense deduction for costs that are later reimbursed by an award or settlement, you must recapture the previously deducted amount by reporting it as income on your tax return.

Oddly enough, amounts paid for lost wages are also tax-free, even though the wages would have been taxable if you had received them.

However, if any part of your award or settlement is deemed to be interest for the period between the physical injury or sickness and the time you get paid, that part is taxable.

Example: Say you were seriously injured in a 2008 auto accident. You racked up $50,000 in medical expenses and $60,000 in lost wages. On your 2008 and 2009 returns, you claimed medical expense deductions totaling $35,000 (you couldn t deduct the full $50,000 because of tax-law limitations on medical write-offs). You eventually received a $520,000 out-of-court settlement that covered medical expenses, lost wages, pain and suffering, plus $20,000 in interest. Only $55,000 is taxable ($35,000 for medical expenses that were deducted and later reimbursed, plus the $20,000 in interest). The remaining $465,000 is tax-free.

Other Payments Are Taxable

Payments for legal (as opposed to physical) injuries from things like harassment, discrimination, wrongful termination, libel and invasion of privacy are taxable. Ditto for emotional distress that s not caused by physical injury or sickness.

Punitive damage awards (amounts paid for the specific purpose of punishing the wrongdoer) are generally taxable, even if they are paid as compensation for physical injury or sickness. There is one exception to this general rule. Tax-free treatment applies to punitive damages paid in civil wrongful death actions when applicable state law only allows punitive damages in such cases.

What About Attorney Fees?

You can t deduct attorney fees incurred to collect a tax-free award or settlement for physical injury or sickness. In other words, no deductions are allowed for fees to collect tax-free compensation. Fair enough. After that, it gets tricky.

Say part of your award or settlement is tax-free (for physical injury or sickness), and part is taxable (for interest or punitive damages). You must report the full amount of the taxable portion of the award or settlement as income on your return, without any reduction for the related attorney fees. Then you can treat the fees related to the taxable portion as a miscellaneous itemized deduction item on Schedule A of your Form 1040. Calculate the deduction by multiplying the total fees by a fraction. The numerator is the taxable portion of your award or settlement, and the denominator is the total amount of the award or settlement.

Unfortunately, because of harsh limitations on miscellaneous itemized deductions, your actual write-off for legal fees may be reduced to little or nothing. If so, you ll be taxed on money that never even made it into your wallet because your attorney snatched it. In this unhappy scenario, you can potentially wind up with only a small fraction of your award or settlement after paying your attorney and the IRS. Of course, this outcome is completely unfair, but such is life when our beloved Congress makes the rules.

Special Rule for Attorney Fees in Discrimination Cases

There is one exception to the unfavorable general rule for attorney fees that I just explained. Fees incurred in certain unlawful discrimination cases can be deducted in full on page 1, line 36 of your Form 1040 without any limitations. That way, you re not taxed on money that goes to your attorney, because you can deduct that amount. For purposes of this beneficial exception, unlawful discrimination is defined as violating any one of a list of laws that mostly have to do with civil rights, labor and employment rights, housing rights, disability rights and whistleblower rights. If your case doesn t involve violating one of these laws, your attorney fees fall under the unfavorable general rule (i.e., miscellaneous itemized deduction treatment applies).

The Last Word

Remember: The issue of deducting attorney fees only arises when we're talking about an award or settlement that s at least partially taxable. Fees related to tax-free compensation for physical injury or sickness are always nondeductible. For more details on the tax rules for damage awards and settlements (and related attorney fees), check out IRS Publication 525 (Taxable and Nontaxable Income) at www.irs.gov.