Are Employment Settlements Taxable Income?

Employment settlements can offer financial resolution for various workplace disputes. While these settlements provide relief, understanding their tax implications is often complex. The tax treatment of settlement payments is not always straightforward, as different components of a settlement may be subject to varying tax rules.

Taxable Components of an Employment Settlement

Most employment settlement components are subject to federal income tax. Payments intended to replace lost wages, such as back pay and front pay, are typically considered ordinary income. These payments are treated as regular wages for tax purposes.

Damages for emotional distress are generally taxable unless directly attributable to a physical injury or sickness. For example, if emotional distress arises from a hostile work environment without a physical ailment, compensation for that distress is taxable. This applies even if emotional distress leads to physical symptoms like headaches, as these are considered symptoms of emotional distress, not standalone physical injuries.

Punitive damages, awarded to punish egregious conduct, are almost always taxable. These damages are not intended to compensate for actual losses but to penalize the wrongdoer. Regardless of the underlying claim, punitive damages are included in gross income for tax purposes, even if the primary settlement amount is non-taxable due to physical injury.

Non-Taxable Components of an Employment Settlement

Some employment settlement components may be non-taxable. The main exception applies to damages for physical injury or sickness. To qualify, the injury or sickness must be a direct result of the employer’s actions, not merely emotional distress. This requires observable bodily harm or a diagnosed physical ailment.

For tax purposes, “physical injury” or “physical sickness” requires more than just emotional distress. For example, compensation for a broken bone or illness directly caused by workplace conditions is typically non-taxable. Conversely, emotional distress not stemming from a physical injury, such as anxiety from harassment, is generally taxable.

However, if emotional distress directly results from a physical injury or sickness, damages for that emotional distress can be non-taxable. For instance, if an individual sustains a physical injury at work and experiences emotional distress related to the pain, that portion of the settlement may be exempt from tax.

Tax Reporting and Withholding

Employment settlements are reported to the IRS using various forms, depending on the payment’s nature and the parties’ relationship. Payments for lost wages, like back pay or front pay, are typically reported on Form W-2, Wage and Tax Statement, if an employer-employee relationship is maintained. These amounts are subject to income tax withholding and FICA taxes.

Other settlement payments, especially to non-employees or for specific legal settlements, may be reported on Form 1099-NEC, Nonemployee Compensation. This form is used for payments of $600 or more for services performed by someone not an employee. Form 1099-MISC might be used for other income types, such as taxable damages not categorized as wages.

Withholding rules vary based on settlement components. Non-taxable physical injury damages are not subject to withholding. Recipients should be aware that if significant amounts are paid without sufficient withholding, they may need to make estimated tax payments to cover their liability. Failing to do so can result in penalties for underpayment.

Deducting Attorney Fees

The tax treatment of attorney fees paid from an employment settlement has specific rules. Generally, attorney fees incurred to produce taxable income are considered miscellaneous itemized deductions. However, under current tax law, these deductions are suspended for tax years beginning after December 31, 2017, and before January 1, 2026. This means most employment-related claims cannot deduct attorney fees on federal income tax returns.

A notable exception exists for attorney fees related to certain unlawful discrimination claims. Under Internal Revenue Code Section 62(a)(20), attorney fees and court costs for specific unlawful discrimination claims can be deducted “above-the-line.” This means these fees directly reduce adjusted gross income, making them more beneficial than an itemized deduction. This deduction is limited to the gross income generated from the lawsuit.

Claims qualifying for this deduction include employment discrimination under various civil rights acts, whistleblower claims, and certain other federal statutes. For other types of employment settlements, such as breach of contract or general tort claims not involving physical injury or specific discrimination, attorney fees remain non-deductible.