Settlement proceeds compensating for emotional distress are taxable. A man who claimed he was subject to a racially hostile work environment sued his employer. As part of a settlement, he got money for emotional distress. He claimed he suffered physical symptoms from the distress, but the Tax Court said that doesn’t make the damages he got tax-free (Collins, TC Summ. Op. 2017-74).
However, there are two extremely limited exceptions to this rule: Amounts paid for mental anguish that arise from physical injuries are nontaxable. The same goes for reimbursements for medical treatment of emotional trauma.