Back Pay Taxes: How Awards and Settlements Are Taxed

Receiving a back pay award, whether from a lawsuit, a settlement agreement, or an employer’s correction of a payroll error, can provide significant financial relief. This compensation covers work you performed in the past but for which you were not paid at the time. Understanding how the Internal Revenue Service (IRS) treats these payments is important for proper tax reporting and avoiding future complications. The structure of a settlement can further complicate matters, as different components of an award may be subject to different tax liabilities.

The Timing and Character of Back Pay Taxation

A foundational principle of back pay taxation is that the income is taxable in the year you receive it, not in the years the wages were earned. This is governed by the doctrine of “constructive receipt,” which states that income is taxable when it is credited to your account or made available to you without restriction. Even if the work was performed over several prior years, the entire lump sum is recognized as income in the single year it is paid out.

This timing rule can have a significant impact on your overall tax liability. Receiving multiple years’ worth of income in a single tax year can push you into a higher marginal tax bracket than you would have been in if you had received the pay when it was originally earned. This can result in a larger percentage of your award going toward federal and state income taxes.

The character of the income is another important aspect. The IRS considers back pay to be wages. This means that, like a regular paycheck, the payment is subject to federal income tax withholding, as well as Social Security and Medicare taxes (FICA taxes). Your former or current employer is responsible for withholding these amounts from your award and remitting them to the government.

The classification of back pay as wages distinguishes it from other types of legal settlements. For example, compensation for personal physical injuries is not taxable. When a settlement includes both back pay and damages for personal physical injury, the portion allocated to back pay remains taxable as wages.

Tax Treatment of Settlement Components

A settlement in an employment-related case is often composed of several distinct elements, each carrying its own tax implications. The settlement agreement should ideally specify the allocation of the funds among these different categories. This allocation dictates which taxes apply and how the income is reported.

Wages

The portion of a settlement that compensates for unpaid work is treated as wages. This amount is subject to the same tax treatment as your regular salary. Federal and state income taxes will be withheld, as will your share of Social Security and Medicare taxes. You will receive a Form W-2 from the payer that includes these wages.

Interest

In many back pay cases, an amount is added to the award to account for the time value of money, compensating you for the delay in payment. This portion is considered interest income, not wages. As a result, it is subject to federal and state income tax but is not subject to FICA taxes. The payer will report this interest to you and the IRS on Form 1099-INT or Form 1099-MISC.

Liquidated Damages

Certain laws, such as the Fair Labor Standards Act (FLSA), allow for the award of liquidated damages in cases of unpaid overtime or minimum wage violations. These damages compensate employees for economic losses from the late payment of wages. Liquidated damages are not considered wages and are not subject to FICA taxes. This income is, however, still subject to federal and state income tax. The payer will report these damages on Form 1099-MISC as “Other Income.”

Attorney’s Fees

In most cases, the entire amount of the settlement, including the portion paid directly to your attorney, is considered part of your gross income. This means you could be taxed on money that you never personally received.

An exception to this rule provides relief for many taxpayers. If your lawsuit involves a claim of “unlawful discrimination,” you can deduct your attorney’s fees as an “above-the-line” deduction on your tax return. This deduction is taken on Schedule 1 of Form 1040 and reduces your adjusted gross income (AGI). This is more favorable than a standard itemized deduction because it is available to all taxpayers, regardless of whether they itemize.

How to Report Back Pay on Your Tax Return

Properly reporting your back pay award on your tax return requires careful attention to the different forms you receive from the payer. Each form corresponds to a different component of your settlement and must be entered on the correct line of your tax return. You will need the forms provided by the payer, which may include a Form W-2 and one or more Form 1099s.

You will transfer the information from these forms to your Form 1040. The amount from your Form W-2, which represents your back pay wages, is added to your other wages for the year. If you received taxable interest, you will report it as interest income. This amount may be reported to you on a Form 1099-INT or Form 1099-MISC.

Income from liquidated damages, reported on Form 1099-MISC, is entered on Schedule 1 (Form 1040) as “Other Income.” If you are eligible to deduct your attorney’s fees for an unlawful discrimination claim, you will claim this as an “above-the-line” deduction on Schedule 1. You should consult the instructions for the current year’s Schedule 1 to find the specific line for this deduction.