William Volz (Wayne State, Business School) & Vahe Tazian (Lear Corp.) have published The Tax Treatment of Sexual Harassment Awards: Clarifying the Threshold for Exclusion, 30 J. Legis. 275 (2004). Here is part of the Conclusion:

Conflicting judicial opinions coupled with the difficulty of equating the psychological harm in sexual harassment and comparable torts to physical injuries highlight the need for regulatory clarification of the standard for excludability. The IRS can address these problems through a regulatory ruling that establishes clear guidelines as to the types of harm that meet and do not meet the statutory threshold for exclusion of a “personal physical injury and physical sickness.” These guidelines should also clarify that damage awards for lost wages and other economic injuries do not qualify for exclusion when, had they not been improperly withheld, they would clearly have been subject to income taxation….

Adoption of the regulatory language proposed here should assist in clarifying the types of injuries that qualify an award for exclusion from gross income under § 104(a)(2). A broad range of interested parties should benefit from the clarification. Damages for sexual harassment are inherently complex, and the continuing uncertainty surrounding these awards should compel the IRS to address the nature of the injuries that are excludable.