Can Malpractice Settlements Be Taxable?

Is a settlement of a malpractice claim against physicians or a hospital considered to be taxable income? 

In short, it depends, but according to a recent Tax Court and Ninth Circuit Appeals Court case, it can be. Let's dig in...

Background: Generally, legal awards and settlements are subject to federal income tax, like most other forms of income. However a special section of the tax law specifically excludes from tax damages that are received on account of personal physical injuries or illness.

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This issue is often contested in the courts when a taxpayer receives a settlement or other damages based on a claim of emotional distress. The new case at hand involves a settlement of a malpractice lawsuit. In this instance, the taxpayer was hurt when she sat in a broken wheelchair at a hospital.

She sued the hospital and lost, but then claimed malpractice by her attorneys and eventually agreed to a settlement. The Tax Court determined that the payment constituted taxable income.