Non-Taxable Portions of Settlements or Awards for Discrimination or Job Termination

The issue of whether money damages received by a settlement or judgment for employment termination or discrimination are subject to income tax has been a much discussed and misunderstood subject.  The issue has been solved now with the answer being that as a general rule ALL money received from a settlement or judgment by reason of employment termination or discrimination is subject to income tax, which includes earnings, mental anguish, attorney fees and punitive damages.  The employee is entitled to deduct the attorney fees and costs of the suit from the recovery but must report the full amount on their income tax and show the attorney fees and costs as a line item deduction.  There is one exception that was discussed in the 2011 Fifth Circuit case, Espinoza v. C.I.R., 636 F.3d 747 (5th Cir. 2011).  In this case the court stated that any proceeds received for back pay or purely for mental pain and anguish would not be received on account of “personal physical injury or physical sickness”, which is not taxable, and thus would be included as income. See I.R.C. § 104(a)(2). However, proceeds received to pay for medical treatments for the physical manifestation of emotional distress or mental pain and anguish may be excludable from income subject to income tax under § 104(a)(2).  Therefore, a plaintiff may want to explore whether he/she has incurred expenses for medical or psychological treatment of the  physical manifestation of emotional distress or mental pain and anguish which would not be subject to income tax.  Presumably, this would include counseling fees related to physical manifestations of emotional distress and mental anguish, hospitalization for the physical manifestation of symptoms, drugs for treatment of depression causing physical problems, high blood pressure, or headaches from the mental anguish, etc..  There may be other examples but the key would be tying the expenses to treatments for the physical manifestation of mental anguish or emotional distress from the termination of employment or other job discrimination.