Proceeds from a settlement involving an employment-related discrimination case may be taxable to the employee under some circumstances and not taxable in others.
Non-taxable settlement amounts:
- Medical expenses associated with medical distress;
- Emotional distress, pain or suffering resulting from a physical injury;
- Personal injury or sickness; and
- Legal costs associated with the case.
Taxable settlement amounts:
- Lost wages;
- Emotional distress, pain or suffering not resulting from a physical injury; and
- Punitive damages.
It is important to know which proceeds are taxable since the worth of a settlement may depend heavily on whether that settlement amount will be decreased by the payment of income taxes. For example, if characterized as punitive damages, a $200,000 settlement may not be as desirable as a $165,000 settlement characterized as payment for personal injury.
Taxability of Emotional Distress Damages
Unfortunately, not everyone involved with an employment discrimination case is familiar with the most desirable settlement characterization for tax purposes, and even if they are, they may not be able to properly characterize the settlement to pass IRS scrutiny. One problematic characterization for many employees is that of emotional distress. One type of emotional distress is taxable and another type is not. In an important employment discrimination case, Wells v. Commissioner, the United States Tax Court further distinguished the types of emotional distress and created a two-part test for determining taxability, as follows:
Wells v. Commissioner: Two-part test for emotional distress in discrimination cases
The plaintiff/employee had an altercation with a supervisor and subsequently filed a discrimination claim. She took leave from work while being treated by a therapist to emotionally recover from stress allegedly caused by this altercation. Ten months after the altercation (eight months of which were spent on leave) she was terminated by her employer. In a settlement, the employee agreed to receive $175,000 and the settlement agreement noted that it was for emotional distress and not for wages-likely an attempt to ensure that it would not be taxable.
However, the Tax Court held that damages for emotional distress (even physical symptoms of emotional distress) are not excludable from ordinary income if they were caused by a non-physical injury such as discrimination. In deciding whether an amount is taxable, the court will look first at the express language of the settlement agreement and what it states the amount was paid to settle; and second to the intent of the payor, and all the facts and circumstances of the case (including the original complaint). In Wells v. Commissioner, because the settlement agreement expressly declared the amount to be for emotional distress (not caused by physical injury) the amount was taxable as ordinary gross income.
Properly Characterizing Settlement Agreements
Both employers and employees should be careful about the characterization of settlement amounts and be diligent in filing information with the IRS and state. A tax attorney can assist the parties in crafting a demand, complaint or settlement that may make the difference between an award non-taxable rather than taxable. Although the tax attorney would always prefer to be part of the case from the beginning, if you have already received your settlement or judgment you want to consult with a tax attorney to determine if your payment can be characterized as non-taxable in whole or in part and if your related expenses are tax deductible.
For more information, contact Moskowitz, LLP.