Last updated March 13, 2018.
So you’ve finally settled your employment lawsuit — what a relief! Now you don’t have to concern yourself with the strength of your case, the pace at which it is proceeding, or whether or not it will resolve without a trial.
You do, unfortunately, have to concern yourself with the tax implications of your settlement. Read on to find out what is taxable, and what is not, so you can best prepare for tax season.
Employment Discrimination Settlement Tax Treatment
There are usually two components to asserted damages in an employment termination claim, and therefore to any settlement of such a claim: (1) compensation for economic losses such as back pay, and (2) compensation for emotional distress harm. Both are considered taxable “income” by the IRS.
Generally, the attorney will negotiate and ultimately agree to an “allocation” in the settlement agreement between compensation for economic losses and emotional distress harm This can vary case by case. If an employee has lost very little money, but has suffered extreme emotional distress, then the allocation could be weighted in favor of emotional distress. If the employee had substantial lost salary, but never suffered much emotional harm, the it can be weighed the other way. What matters to the IRS is that the agreed-upon allocation be reasonable and reflective of the actual claims and facts asserted in the lawsuit.
- Payment of Back-Pay Damages as a Payroll Check: That portion of the settlement proceeds that is allocated to lost salary is usually paid as a payroll check with the applicable withholdings. The employer reports this check to the IRS via a W-2 form.
- Payment of Emotional Distress Damages as a Lump-Sum Check to Plaintiff: The other portion of the settlement proceeds that is allocated to “emotional distress” damages is paid simply as a lump-sum check without any deductions, and must be reported to the IRS via a 1099 form.
Physical Harm and Taxes on Settlements
Under Section 104(a)(2) of the Tax Code, only settlement funds that compensate a plaintiff for damages arising from physical injuries or physical sickness are not considered taxable income. According to IRS memorandum and guidelines, this exemption only applies to “observable” physical bodily harm that is capable of being documented — i.e., cuts, bruises, broken limbs and the like.
As a practical matter, plaintiffs in employment lawsuits will very seldom qualify for this exemption. A worker who sued his employer for racial discrimination suffered at the hands of co-workers, for instance, cannot claim an exemption for the stress, humiliation, and mental suffering he endured while being subject to racial taunts. The only way he could safely qualify for an exemption is if he can prove physical harm resulting from the discrimination, such as a blackened eye from a racially-motivated assault.
There is, however, a small silver lining. If an employee’s emotional damages resulted in medical expenses such as psychiatric visits and prescription medications, those medical expenses are deductible.
Like emotional damages, the portion of a settlement dedicated to punitive damages is taxable, exempt only from payroll taxes.
Employment Lawsuit Settlement Taxes and Attorney Fees
Compensation for attorney fees is generally not taxable. The portion of a settlement dedicated to an attorney’s fees is treated as an “above the line” tax deduction when calculating the employee’s adjusted gross income. Often, a separate 1099 will be issued to the attorney, and the attorney will be responsible for paying his or her taxes on the attorney fees.
The foregoing is meant solely as a general overview of the taxability of employment lawsuit settlements. The tax issues with respect to any legal settlement are myriad and complex, and should be discussed in depth with your attorney and accountant.
Have more questions about tax consequences of settling an employment claim? Contact us online or call our offices today for a free consultation. Our practices areas include racial and ethnic discrimination, sexual discrimination and harassment, and age discrimination.
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- Time off from Work for Religious Observances: What is Reasonable and What is Undue Hardship?
- What Does Pregnancy Discrimination in the Workplace Look Like?
- Can My Employer Discriminate Against Me Because I’m Separated or Divorced?