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I Settled My Employment Lawsuit, Do I Owe Taxes?

Taxation of employment discrimination settlements has become a hot topic in some quarters as the number of these legal actions has increased in recent years. wrongful termination, age discrimination, gender discrimination, sexual harassment and racial discrimination litigation are areas where settlement may include a tax bite. If you are a plaintiff in one of these causes of action, be mindful of income tax when you settle the case.

A key factor is how the settlement agreement is drawn up with regard to the nature of the funds being dispersed. When a settlement agreement specifically allocates proceeds among types of damages, that is normally binding for tax purposes as long as it is made in good faith within an adversarial context. Money may be allocated for various things such as lost wages, medical bills, punitive damages, pain and suffering etc. The specificity of the amounts in the money damages is critical in determining the taxation of the award. Things that are generally not taxable may wind up on a W-2 or 1099 if a defendant can find a way to exploit ambiguity.

Recently a Federal Appeals Court ruled that a wrongful termination settlement was subject to income and FICA tax (Gerstenbluth v. Credit Suisse). After he settled his case, the plaintiff was issued a W-2 by his former employer that included the funds in the settlement. His settlement agreement did not address taxation or the exact nature of the payment. IRS determined it was for lost wages and agreed with the former employer. The amount of lost wages in a settlement determines FICA tax and impacts income tax.

Often the defendant in a case pays the legal fees of the plaintiff once it is settled. In a private letter ruling, IRS says that legal fees may be treated as wages in certain cases. Therefor, one wants an agreement that clearly defines the nature of the award so a grey area can be avoided that may be exploited by an employer. If there is no specific allocation in the settlement, then full taxation can occur. If it is specified then no FICA may be due, just income tax. However, the plaintiff may be able to deduct the amount of legal fees as an “above-the-line” deduction on the Form 1040 if they were included as income on a W-2 or 1099.

Punitive Damages are taxable. Liquidated Damages are also generally taxable. Pain and suffering awards may be tax free in most cases just as is payment for medical bills. Usually this involves a personal injury matter. Please consult an Enrolled Agent, CPA, or Accredited Tax Advisor prior to final settlement of one of these types of cases for advice on the tax treatment or when preparing your taxes after settlement.

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