According to the IRS in Publication 4345, damages for claims involving death are considered to be compensation for physical injuries. They are generally free from income tax for the survivors. However, it is important to note that if your loved one left a sizeable estate, damages in this type of lawsuit might push the value of the estate above the federal estate tax exemption. Arizona does not have an estate tax. The federal exemption may still apply if your loved one's estate was worth more than $11.18 million. Most people will not need to worry about this issue.
If you receive punitive damages, you may be required to report them as income on your income tax return. Finally, if your settlement agreement contains a nondisclosure clause, the IRS can claim that it was bargained for and make all of the award subject to taxation. You should avoid signing an agreement that contains a nondisclosure clause unless you secure an agreement from the defendant that he or she will defend against the IRS and indemnify you if you are charged taxes on your settlement.