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January 19, 2024

Will your court awards and out-of-court settlements be taxed? 

Courts grant monetary awards and settlements for a range of reasons. 

For example, you may receive compensatory and punitive damage payments for personal injury, discrimination, or harassment. In this situation, some of the awarded amount you receive may be taxed by the federal government, and perhaps some will be taxed by your state government. 

Hopefully, you’ll never need to know how payments for personal injuries are taxed, but here are the basic rules if you or a loved one receive an award or settlement and need to understand the tax implications.

Under current tax law, you’re permitted to exclude from your gross income the damages received on account of a personal physical injury or a physical sickness. It doesn’t matter if the compensation is from a court-ordered award or an out-of-court settlement, and it makes no difference if it’s paid in a lump sum or installments.

Exceptions: Emotional distress, punitive damages, back pay

Emotional distress isn’t considered a physical injury or physical sickness and is excluded from the tax exemption. So, for example, you would need to include an award under state law that’s meant to compensate for emotional distress caused by age discrimination or harassment in your gross income. However, if you require medical care for treatment of the consequences of emotional distress, then you may exclude the amount of damages not exceeding those expenses from gross income.

Punitive damages for any personal injury claim, whether physical or not, aren’t excludable from gross income unless the court awards it under certain state wrongful death statutes that provide for only punitive damages.

The law doesn’t consider back pay and liquidated damages you may receive under the Age Discrimination in Employment Act (ADEA) to be paid in compensation for personal injuries. Therefore, if you receive an award for back pay and liquidated damages under the ADEA, you must include those awards in your gross income.

Court case examples

As you may suspect, the IRS and courts often decide that awards and settlements are taxable even if the recipient feels they should exclude them from taxable income. 

In one case, a taxpayer sustained an injury while at a hospital. She sued for negligence but lost her case. She then sued her attorney for legal malpractice, and the court awarded her $125,000. The IRS said the amount was taxable because her award wasn’t for any physical injuries. The U.S. Tax Court and the 9th Circuit Court of Appeals agreed. (Blum, 3/23/22)

In another case, the Tax Court ruled that married taxpayers weren’t entitled to income exclusion for a settlement the husband received from his former employer in connection with an employment discrimination and wrongful termination lawsuit. Although the settlement agreement provided for payment “for alleged personal injuries,” there was no evidence to support that it was paid on account of physical injuries or sickness. (TC Memo 2022-90)

Legal fees

You aren’t allowed to deduct attorney fees you incur to collect a tax-free award or settlement for physical injury or sickness. However, to a limited extent, attorney’s fees (whether contingent or non-contingent) or court costs paid by, or on behalf of, a taxpayer in connection with an action involving certain employment-related claims are currently deductible from gross income to determine adjusted gross income.

After-tax recovery

Keep in mind that while you want the best tax result possible from any settlement, lawsuit, or discrimination action you’re considering, non-tax legal factors, together with the tax factors, will determine the amount of your after-tax recovery. Consult with your attorney on the best way to proceed, and we can provide any tax guidance that you may need.

Questions? Smolin can help.

This article provides a basic overview of the tax implications of court awards and out-of-court settlements. If you need tax information about your award or settlement, the best course of action is to consult with your accountant.

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