You don't have to pay taxes on this and it does not need to be declared on your return.
Compensation you receive for permanent
loss or loss of use of a part or function of
your body, or for your permanent disfigurement.
This compensation must be based
only on the injury and not on the period of
your absence from work. These benefits
are not taxable even if your employer pays
for the accident and health plan that provides
these benefits.
The above is from page 19 of 40 of the IRS Publication 525. The link is: https://www.irs.gov/pub/irs-pdf/p525.pdf
Note: The IRS has not updated the Publication 525 for 2016, however this law has not changed.
