How Do Taxes on a Back Pay Settlement Work?

Receiving a settlement for back pay from a legal claim like wrongful termination can provide financial relief. However, these awards are considered taxable income by the Internal Revenue Service (IRS). The rules governing how these settlements are taxed can be intricate, involving multiple components and specific reporting requirements. Understanding the tax implications is necessary to properly manage settlement funds and meet federal tax obligations.

Taxable Components of a Back Pay Award

A back pay award is rarely a single amount; it is composed of several distinct elements, each with its own tax treatment. The core component is the back wages themselves. This portion is considered ordinary income and is subject to the same taxes as regular pay, including federal and state income taxes, as well as Social Security and Medicare (FICA) taxes.

A settlement will often include an amount for interest on the delayed wage payments. This interest is intended to compensate the recipient for the time they were without their earned money. For tax purposes, this interest is taxable as investment income, meaning it is not subject to FICA taxes but is subject to ordinary income tax rates.

Another common element is liquidated damages. These are payments awarded under laws like the Fair Labor Standards Act (FLSA) as a penalty against the employer. These payments are taxable income but are not considered wages for FICA tax purposes and are taxed at the recipient’s regular income tax rate.

Finally, a settlement may include compensation for emotional distress. According to Internal Revenue Code Section 104, damages received for personal physical injuries or sickness are not taxable. However, most back pay cases do not involve a physical injury, meaning any award for emotional distress is almost always taxable income.

Withholding and the Year of Taxation

The IRS applies the “year of receipt” rule, meaning the entire settlement amount is taxable in the year it is physically received by the individual or their attorney. This holds true regardless of the period the back pay actually covers. This can create a substantial tax burden in a single year, potentially pushing the recipient into a higher marginal tax bracket.

When the settlement payment is made, the employer is responsible for withholding taxes on the portion classified as wages. Employers often use the supplemental wage withholding method, which applies a flat rate of 22% for federal income taxes on these payments. This rate may be higher or lower than the recipient’s actual tax rate for the year, potentially resulting in either a large refund or a tax bill.

While income tax is based on the year of receipt, a special rule applies to FICA taxes. For Social Security and Medicare taxes, the back wages are allocated to the years in which they were originally earned. This affects the Social Security wage base limit for those prior years. If the allocated back pay in a prior year does not exceed that year’s Social Security wage limit, additional Social Security tax will be due.

Deducting Attorney Fees and Costs

A taxpayer’s gross income from a lawsuit settlement includes the portion paid directly to their attorney. This means the recipient is initially taxed on the full settlement amount, not just the net amount they receive after legal fees are paid.

Tax law provides a way to offset this through a deduction. For lawsuits involving claims of “unlawful discrimination,” a taxpayer can deduct their attorney fees and other legal costs. This is an “above-the-line” deduction, which is reported on Schedule 1 of Form 1040.

This type of deduction is advantageous because it reduces the taxpayer’s adjusted gross income (AGI) and is available even if they do not itemize deductions and instead take the standard deduction.

This deduction is not available for all types of legal claims. It is specifically limited to cases involving unlawful discrimination, which includes actions brought under federal and state laws that protect against discrimination based on race, sex, religion, age, or disability. If the legal claim does not fall into one of these specified categories, the attorney fees are not deductible.

How to Report Settlement Income

The paying party is required to issue tax forms that report the payments to both the recipient and the IRS. The specific forms depend on the components of the award. For the portion representing back wages, the recipient should expect to receive a Form W-2, which will show the wages and the amounts withheld for income and FICA taxes.

If the settlement included an interest component, that amount will be reported on Form 1099-INT. Other taxable portions of the award, such as liquidated damages or taxable emotional distress damages, are reported on Form 1099-MISC or Form 1099-NEC. It is the recipient’s responsibility to ensure these forms and the information reported are accurate.

When filing a tax return, this income must be correctly placed.

• Wages from Form W-2 are reported directly on Form 1040.
• Interest income from Form 1099-INT is reported on Schedule B.
• Income from a Form 1099-MISC is reported on Schedule 1 as “Other Income.”
• If an above-the-line deduction for attorney fees is applicable, it is also claimed on Schedule 1.