Taxation of Awards or Settlements

Since today is April 15th, let’s talk about the income taxation of jury awards or settlements in discrimination or job termination cases.  This has been a very confusing area in the past because recoveries in cases involving physical injuries (such as in a car wreck where a person breaks a leg or hurts their back) the entire recovery, no matter how it is designated as to salary, earnings, physical pain/ mental anguish, or medical expense is not subject to income tax and is not included in your gross income.  However, any jury award or settlement for loss of earnings or mental anguish in a non-physical injury case, such as for wrongful termination or discrimination is subject to income tax.  So, in a case involving physical injury, the recovery for mental anguish or physical pain and lost pay is not taxable; but, in a non-physical injury case, the recovery for mental anguish and lost pay is taxable.  Also, any recovery for punitive damages is taxable.    In a settlement, most companies who pay a settlement usually reduce the amount paid for loss of  pay by the amount that would have been withheld for income tax and send this to the IRS, as they would wages had the person still been employed.  This amount is credited to the former employee’s income tax account, as payment of income tax for the year in which it is paid.  Many times, the settlement is structured so as to hold the lost income amount to a smaller figure in order to reduce the required withholding.  Attempts have been made in Congress to amend the IRS code to make settlements in employment discrimination cases tax free as they are in personal injury cases; however, this revision has not passed yet.