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The phrase “on account of” is important. Many cases have been litigated where the taxpayer has attempted to exclude from income awards based on emotional distress. Overwhelmingly, courts have held that in order for damage awards to be excluded from gross income they must have been received on account of personal physical injuries or physical sickness.
To be excludible, an emotional distress recovery must be on account of (attributed to) personal physical injuries or sickness unless the amount is for reimbursement of actual medical expenses related to emotional distress that was not previously deducted under IRC § 213.
The settlement would not be excluded from tax.
Yes, it is still taxable.
The physical injury or sickness would need to be the main reason for the settlement.
The sickness in this case was not caused by the employer.