Settlement of Your Case

Tax liabilities are an important consideration, especially in the context of employment cases.  Most employment claims are governed by statutory causes of action, which can allow for a host damages: compensatory, back/front pay, punitive, and/or attorneys’ fees.  When resolving an employment lawsuit, it is important to understand tax implications of these different damage categories, and how each is treated for purposes of settlement. 


In employment cases, plaintiffs often request defendant employers to designate settlement payments in such a way to avoid income tax with holdings. While this may result in a larger settlement check for the plaintiff—and perhaps an easier settlement negotiation for the employer—doing so could subject both parties to substantial tax liability down the road. If settlement proceeds are mis-classified to avoid income taxes, the plaintiff-employee might be held responsible for all taxes, including the employer’s unpaid portion. And if the employee is unable to satisfy the tax burden, the IRS can look to the employer to foot the bill. 


Moreover, where an employer fails to deduct and withhold taxes for wage payments made to an employee, the employer may be subject to additional liability, penalties, and interest. See 26 U.S.C. § 3509. Because of the potential exposure to employees and employers for inaccurate tax reporting, all parties should make it a priority to allocate settlement payments accurately based on the facts and circumstances of the settled claims.  

Allocating Settlement Proceeds 


Settlements are taxed according to the potential damages available to the employee.  It is wise to designate the settlement proceeds during negotiations, instead of leaving that determination to post-settlement discussion.  Soon after the determination is made, it should be memorialized in a signed settlement agreement, which is generally given deference by the IRS, as long as the agreement was negotiated at arms’ length and in good faith. See, e.g., Bagley v. Comm’r, 105 T.C. 396, 406 (1995), aff’d 121 F.3d 393 (8th Cir. 1997). 


Still, a settlement allocation is not binding on the IRS, and the IRS may disregard an agreement if the facts and circumstances indicate that the parties actually intended the payments to be made in compensation for different damages.  Robinson v. Comm'r, 102 T.C. 116 (1994).  An inquiry into the tax treatment of settlement funds generally hinges on the employer’s primary reason for making the settlement payment.  Thus, the settlement agreement should set forth the rationale for any allocation of damages.


Nothing herein creates an attorney-client relationship between the Reader and Us. The information in this document is subject to change and the Reader should not rely on the statements in this document without first consulting a tax attorney or your accountant.    THIS IS AN ADVERTISEMENT.


Tax Implications

 As a general rule, almost all settlement payments in an employment lawsuit are includable in the plaintiff’s taxable income (subject to limited exceptions for physical injuries and medical expenses)—but this does not mean that the settlement funds are subject to income tax withholdings.  The settlement agreement should specify which payments are made for lost wages (both back and front pay), which are subject to income tax withholdings and reported via a Form W-2, and which payments are made for non-wage recoveries (e.g., payments for emotional distress or attorneys’ fees) that are not subject to income tax or withholding.  


Monies received for physical injuries (i.e., observable or documented bruises, cuts, swelling or fractures) are excluded from the plaintiff’s income.  All damages that flow from a physical injury or physical sickness are also excludable, even if the recipient of the damages is not the injured party (e.g., damages received by an individual on account of a claim for loss of consortium due to the physical injury of that individual’s spouse).  Payments for medical expenses, whether incurred to treat physical or non-physical injuries, are also not considered income.  Note, however, that unlike other tort actions, physical injuries are generally not present in employment cases, except perhaps where there is a claim for unwanted physical contact resulting in physical injury (i.e., a battery-like offense). 


Emotional distress and other nonphysical injuries are deemed income to a plaintiff but are not subject to payroll taxes.  These awards should be reported as “other income” (box 3) on Form 1099-MISC.  This is true even if the emotional distress produces physical symptoms.  (However, emotional distress damages attributable to personal physical injuries are excludable from income.) 


Like emotional distress, punitive damages are taxable income to the plaintiff but are not subject to payroll taxes. Punitive damages, including punitive damages received on account of physical injuries or physical sickness, are reported on Form 1099-MISC. 


Lastly, prejudgment interest is considered income to a plaintiff, but it is not subject to payroll taxes.  Greer v. Comm'r, TC Memo 2000-25 (Jan. 19, 2000).  Prejudgment interest is reported on Form 1099-MISC. 

Because it is important that all parties report the payments consistently on their tax returns, the settlement agreement should specify whether a Form W-2 or Form 1099 will be issued to the recipient.  It is important to consult with a tax professional to ensure proper tax reporting. 

Nothing herein creates an attorney-client relationship between the Reader and Us. The information in this document is subject to change and the Reader should not rely on the statements in this document without first consulting a tax attorney or your accountant.    THIS IS AN ADVERTISEMENT.





Douglass Law Group

207 Shore Road, Suite 2.

Somers Point, NJ 08244


T: 609-788-3595


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