The tax treatment of awards received as the result of a lawsuit could result in taxable or non-taxable income, depending upon a number of issues. The laws are often complex and sometimes seemingly discriminatory. The actual taxation of an award is primarily based on the following factors:
- The nature of the legal action,
- The type of award, and
- Whether a settlement occurred before trial
Generally, all monetary awards as the result of a legal action are fully taxable, with one exception. Under the exception, the tax code allows an exclusion from gross income for damages received due to a personal physical injury or physical sickness. Consequently, when a lawsuit is based on a physical injury or sickness, all damages (other than punitive damages, which are generally always taxable) flowing from that suit are treated as payments received due to a physical injury or sickness and are therefore excludable from income. This is true whether or not the recipient of the damages is the injured party.
Here are some commonly encountered situations and their taxability:
Age Discrimination: Tax law doesn’t consider back pay or liquidated damages received under the Age Discrimination in Employment Act (ADEA) to be compensation for personal injuries; therefore, these payments are fully taxable.
Emotional Distress: Emotional distress isn’t considered a physical injury or physical sickness and is therefore taxable. However, if an amount of an award or a settlement is paid for medical care related to emotional distress, that amount may be excludable; see Medical Expenses below.
Employment Discrimination: No exclusion is allowed for damages received in a suit involving employment discrimination or an injury to reputation that is accompanied by a claim of emotional distress.
Interest: Interest that may be included in an award, even one for personal injury or sickness, is not excludable and must be included in gross income.
Previously Deducted Medical Expenses: Generally, when a settlement or award includes reimbursement for medical expenses—such as awards for physical injury, physical sickness and even emotional distress – that portion of the award is excludable. However, any portion of those expenses that was previously allowed as a medical deduction would be taxable.
Punitive Damages: Punitive damages are made as a punishment for unlawful conduct and are always taxable; they cannot be excluded from income like damages received due to personal physical injury or physical sickness, except as noted below for wrongful death.
Wrongful Death: Wrongful death is considered physical injury or physical sickness for purposes of the income exclusion. In addition, punitive damages are excludable where state law provides that only punitive damages can be awarded in wrongful death suits.
Unpaid or Disputed Employment Earnings: Back pay, severance pay, overtime pay, etc., are all treated as W-2 type income and are both taxable and subject to payroll FICA withholding.
It is not uncommon in legal actions for the plaintiff to sue for both excludable and non-excludable damages. For example, an employee is injured on the job and sues for back vacation pay of $10,000 and damages for personal injury of $90,000 (a total of $100,000). If the suit is settled for $50,000 without a stipulation of how the settlement will be applied, the settlement will need to be allocated in the same manner as the original suit. In this example, $5,000 of the settlement would be allocated for back vacation pay (taxable), and $45,000 would be for personal injury (excludable).
Prior to the passage of the Tax Cuts and Jobs Act (TCJA), legal costs associated with personal or employment-related legal actions could only be deducted as a miscellaneous itemized deduction on the employee’s Schedule A itemized deductions, reduced by 2% of the taxpayer’s adjusted gross income (AGI). However, the TCJA suspended the deduction for itemized deductions subject to the 2% of AGI floor for years 2018 through 2024. As a result, for those years, a taxpayer will have to include the full amount of the taxable settlement or award in income and will be unable to deduct the amount paid to the attorney.
So, don’t spend any of that settlement or award money before determining what the government’s cut is. The experts at Henssler Financial can help you determine if you owe any taxes, if any actions can be taken to reduce the tax or if any pre-payments of tax need to be made. If you have any questions, please contact us: