A recent Ninth Circuit decision, Roman v. Commissioner (Mar. 18, 2026), reinforces how narrow the tax-free treatment of settlement proceeds is. In most cases, settlement payments are taxable unless they clearly compensate for physical injury or sickness. Missing that distinction can be costly.
The Core Rule: Physical Injury Required
Under IRC § 104(a)(2), settlement proceeds are excluded from income only if they are paid on account of personal physical injuries or physical sickness.
Generally excludable:
- Physical injuries (e.g., accidents, assaults)
- Physical illness or disease
- Medical expenses for physical conditions
- Pain and suffering tied directly to physical injury
Generally taxable:
- Emotional distress (unless caused by physical injury)
- Lost wages or back pay
- Employment claims (discrimination, wrongful termination)
- Punitive damages (with rare exceptions)
- Interest on settlements
- Business-related claims
Key: What was the payment actually for? It is not enough that a taxpayer suffered physical symptoms or health problems. The payment itself must directly compensate for physical injury or sickness.
What Happened in Roman v. Commissioner
In Roman v. Commissioner, the taxpayer received settlement proceeds from housing-related disputes and argued that the payment should be excluded from income because of physical health problems connected to the living conditions. The courts disagreed.
The Tax Court found, and the Ninth Circuit affirmed, that the taxpayer did not prove the settlement payment was made on account of personal physical injuries or physical sickness. The record did not establish the required direct link between the payment and any qualifying injury.
The result was costly:
- The settlement amount at issue was treated as taxable income
- The taxpayer also faced accuracy-related penalties under IRC § 6662
The case is a reminder that courts do not look only at what happened to the taxpayer. They look at why the payment was made.
Burden of Proof: On the Taxpayer
Courts presume settlement proceeds are taxable unless proven otherwise.
To support exclusion, taxpayers need:
- Medical records showing physical injury or illness
- Complaints or claims seeking physical injury damages
- Settlement agreements clearly allocating payments
- Evidence the allocation reflects the actual dispute
Without this, exclusion typically fails.
Special Situations
Emotional distress
- Not excludable on its own
- Medical costs may be deductible under IRC § 213, but not excluded
Employment settlements
- Usually taxable as ordinary income
- Wages: reported on Form W-2 (subject to payroll taxes)
- Other amounts: Form 1099-MISC or 1099-NEC
- Legal fees may be deductible in limited cases (IRC §§ 62(a)(20)–(21))
Punitive damages
- Taxable, except rare wrongful death cases where only punitive damages are allowed by state law (IRC § 104(c))
Why Settlement Agreement Language Matters
A settlement agreement can help or hurt the tax result. Strong documentation usually includes:
- Clear identification of the claims being resolved
- Specific allocation of amounts among different categories of damages
- Consistency between the agreement, the pleadings, medical records, and the litigation record
But there is an important limit: the IRS is not required to accept a settlement allocation just because the parties wrote it into the agreement. If the allocation appears self-serving or does not match the facts, the IRS can challenge it.
In other words, substance over form.
Accuracy-Related Penalties Can Add Up
Improperly excluding taxable settlement income can trigger penalties under IRC § 6662.
In many cases, the penalty is 20% of the tax underpayment.
That is on top of the tax itself, plus any interest. A taxpayer may try to avoid penalties by showing reasonable cause and good faith, often based on reliance on qualified professional advice.
Practical Takeaways for Plaintiffs, Defendants, and Advisors
If you are negotiating or documenting a settlement, the tax analysis should happen before the agreement is signed. Not all advisors include tax analysis in their representation. If it is excluded, then advice from a tax professional should be sought.
Best practices
- Identify early whether any part of the case truly involves physical injury or physical sickness
- Make sure the complaint and supporting record match that theory
- Gather medical records and other contemporaneous evidence
- Draft settlement language carefully
- Use allocations that reflect the real substance of the dispute
- Get tax advice before the return is filed, not after the IRS raises the issue
Bottom Line
If you are asking, “Are settlement proceeds taxable?” the safest starting point is yes.
The main exception under IRC § 104(a)(2) is limited to damages paid on account of personal physical injuries or physical sickness. Roman v. Commissioner shows that courts will enforce that rule strictly. If the payment is not clearly tied to physical injury, and the record does not support that position, the settlement will likely be taxable.
That makes planning, documentation, and careful drafting essential.
This article provides general information about the federal tax treatment of settlement proceeds and recent guidance from Roman v. Commissioner. It is not legal or tax advice. Tax treatment depends on the specific facts, claims, and settlement terms involved.