Taxes Can Hit Legal Settlements Hard

Q: Dear Attorney Howayeck, in 1998 I settled an employment discrimination claim against my former employer. As a result of my claim, I received a settlement for my emotional distress. I just received a 1099 from my old employer. Are emotional distress damages taxable? Lisa S.

A. Yes, unlike personal injuries, which are excludable from gross income, emotional distress damages are not excludable. Most employment discrimination awards involve back wages or non-physical injuries, rather than physical injuries. For example, settlements received in age discrimination cases or injury to reputation cases are non-physical injuries, as such, included in your gross income.

In the Small Business Job Protection Act of 1996, the bill increased the minimum wage, however, Congress added a provision making all awards not based on “physical injuries or physical sickness” taxable. As such, you were taxed on your settlement regardless of how those injuries are designated in the settlement agreement.

For the most part, both plaintiff and defense attorneys find this law difficult to work with because the parties can no longer designate a certain portion of the award as “nontaxable,” thus increasing the amount needed to compensate plaintiffs fully for their losses. Ultimately, this means fewer cases settle, and more cases go to trial, utilizing judicial resources and clogging our courts.

Back wages are also taxable income, and the current IRS regulations also require that a lump-sum back-pay award be attributed to and taxed in the year in which it is received, regardless of when it would have been received. This often places discrimination victims in a higher tax bracket than they would have been in had they not been discriminated against and received their wages while continuing to work for the employer. There is currently no averaging of the award over the several years for which it may have been designed to compensate.

You may also be taxed on the portion of the award paid as attorneys’ fees. The award is actually taxed twice since your attorney will be taxed on it as well. A recent First Circuit decision and current IRS policy reject the argument that attorneys’ fees are an “employee business expense” for which an employee can take an above-the-line deduction (subtracting directly from gross income). Therefore, you must take the attorneys’ fees portion of the award as a below-the-line “miscellaneous itemized deduction,” which is subtracted after gross income is calculated. Due to the limitations on such deductions, and the existence of the alternative minimum tax, you may be taxed on the entire award, even the percentage that is the attorney’s fee, based upon a contingency agreement.

As a result of the current law, a large portion of your damage award or settlement may be consumed by taxes. Victims of discrimination who obtain compensation intended to “make them whole,” end up being taxed at a higher rate than those who never suffer discrimination, who do not suffer wage fluctuation and are not forced to hire attorneys.

You voice a very important issue. You and others can help change the law. It is obviously too late in your situation. However, you can help other individuals who will be in your situation next the tax year and years to come. Call or write to your Congressional representative voicing your concern and ask his or her position. Ultimately, before settling any claim, find out the tax consequences.

Punitive damages are also taxable as ordinary income, regardless of the underlying physical or nonphysical personal injury.