Taxability of settlement
1. Economic damages
You must include as part of your taxable income any damages that you receive as economic damages (that is, back pay, front pay, and lost benefits). Remember that, according to federal income tax law, your gross income includes all “income from whatever source derived.”
2. Physical injuries or physical sickness
Damages (other than punitive damages) of personal physical injuries or physical sickness, however, are not included as gross income. Thus, if you have suffered any physical injuries or physical sickness as a result of injuries in the workplace (such as a battery), your attorney should make sure that the settlement or severance agreement allocates the damages so that some or all of the damages count as physical injuries; the rest can be allocated to the other claims.
3. Emotional distress
Federal tax law does not consider emotional distress a physical injury or physical sickness. Thus, emotional distress damages are taxable as gross income. However, damages received on account of medical expenses that you incurred because of the emotional distress are excluded from taxable income.
4. Seek the advice of a tax lawyer
If you have been awarded damages in an employment discrimination case, you should retain a tax lawyer who can advise you regarding the tax consequences of the settlement. Your tax lawyer can help you avoid adverse tax consequences by reviewing your proposed settlement agreement and suggesting changes to the language so that your tax liability is minimized.