Article on Law.com regarding a ruling out of the Federal Appeals Court for the DC Circuit that emotional distress damages are considered income and are therefore taxable, unlike damages for physical injury which are not taxable. Maritta Murphy was awarded damages for emotional distress and loss of reputation. Lower courts said these awards were in the nature of a physical injury and were thus not income and not taxable.
The appeals court concluded that taxable income includes compensatory damages for non-physical injuries. In the opinion Judge D. Ginsburg states, “Murphy no doubt suffered from certain physical manifestations of emotional distress”; but the award was for mental pain and anguish and injury to professional reputation. The court separated out the physical injury component that is necessarily involved in an emotional distress injury award and totally ignored the physical aspect. They could have evensaid that a portion of the damages were non-physical, say a random percentage, but instead decided to call the whole thing a a non-physical injury.
Edit: Here is a great in-depth discussion of this case at Taxprof Blog.