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December 30, 2021

Tax Rules for Court Awards and Out-of-Court Settlements


tax rules

There are a number of reasons why you may be provided with an award or settlement—including compensatory and punitive damage payments for discrimination, harassment, or personal injury. If so, some of the amount is subject to federal taxes and may also be taxed at the state level.

Hopefully, you won’t ever experience a personal injury that may lead to an award or settlement—but these basic rules can help you understand the tax implications if you or a loved one ever needs to.

Current tax law permits individuals to exclude damages received due to personal physical injury or physical sickness from their gross income—regardless of whether the compensation comes from a court-ordered award or an out-of-court settlement and whether it’s paid in a lump sum or paid in installments.

Emotional distress, punitive damages, and the ADEA

Emotional distress doesn’t qualify as a physical injury or physical sickness for the purposes of this exclusion. If you receive an award or settlement as compensation for emotional distress caused by harassment or discrimination, you’ll still need to include this amount in your gross income. However, if the consequences of this emotional distress cause you to require medical care or treatment, then you are allowed to exclude the amount of damages not exceeding those medical expenses from your gross income.

Punitive damages provided for personal injury claims can’t be excluded from gross income, even if the claim is for a physical injury. The only exception is for punitive damages awarded under some state wrongful death statutes that only provide for punitive damages.

Back pay and liquidated damages provided under the Age Discrimination in Employment Act (ADEA) aren’t considered by law to be paid in compensation for personal injuries and can’t be excluded from gross income.

Deducting attorney’s fees and court costs

Attorney’s fees can’t be deducted if you incur them in collecting a tax-free settlement or award for physical injury or sickness. However, in the case of actions involving a claim under the ADEA, attorney’s fees (both contingent and non-contingent) and court costs may be deducted from gross income to a limited extent to determine adjusted gross income. The specific amount of this above-the-line deduction is limited to the amount provided due to a judgment or settlement resulting from the ADEA claim that is includible in your gross income for the tax year, regardless of whether this amount is provided due to a suit or agreement and whether it is paid as a lump sum or in periodic payments.

Getting the most favorable tax result

If you’re pursuing a lawsuit, settlement, or discrimination action, you’ll want to pursue the best tax result possible—but it’s worth noting that both tax factors and non-tax legal factors will determine the amount you can recover after tax. If you have further questions on the best way to proceed, consult with your attorney or contact us for additional tax guidance.

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