On August 21, 1996, President Clinton signed the Small Business Job Protection Act of 1996. Taxation of damages was affected by this bill. No longer are damages attributable to emotional distress excluded from taxable income.
Under the new law, the exclusion from gross income of damages received on account of personal injury or sickness apply only to damages which are received on account of a physical injury or physical sickness.
If the claim resulting in damages or settlement payments has its origin in a physical injury or sickness, then all damages (other than punitive damages) that flow from that injury or sickness are treated as payments on account of that physical injury or sickness. If, however, the claim has its origin in emotional distress, even if subsequent physical injury or sickness is alleged, damages or any settlement payment made is taxable because it stems from a nonphysical injury. (Damages which reimburse the cost of medical treatment are not taxable).
Punitive damages, whether attributable to physical injury or emotional distress, are subject to tax under the new law.
Effective Date
Exclusion from income for payments resulting from emotional distress or nonphysical injury claims are only available if paid before the date of enactment of the new law, or no later than August 20, 1996. However, if payments are received later under a written binding agreement, court decree or mediation award which was in effect on or issued before September 1, 1995, they are not subject to the new law.