Article Highlights:
- Complex Area of Tax Law
- Physical Injury and Physical Illness
- Wrongful Incarceration
- Emotional Distress
- Wrongful Death
- Employment Discrimination and Sexual Harassment
- Punitive Damages
- Egg Donor Pain and Suffering
- Interest
- Employer-Related Issues
- Injury to Capital and Lost Profits
- Business-Related Damages
- Deductibility of Attorney Fees
- Out of Court Settlements
The taxation of damages and their deductibility by the payer is a complex area of tax law that intersects with various types of legal settlements and court awards. This article aims to dissect the intricacies of how different forms of damages—ranging from personal to business-related—are treated for tax purposes for both the recipient and the payer. We will explore the tax implications of physical injury, physical illness, wrongful incarceration, emotional distress, wrongful death, employment discrimination, sexual harassment, punitive damages, employer-related issues, injury to capital, lost profits, egg donor pain and suffering, and interest on delayed settlements.
Physical Injury and Physical Illness
Damages received for physical injury or physical illness are generally excludable from the recipient’s gross income, meaning they are not taxable. This exclusion applies to both lump-sum payments and periodic payments. The rationale behind this tax treatment is to not penalize individuals for receiving compensation that essentially makes them whole for the injuries or illnesses they have suffered. However, it’s important to note that any portion of the settlement that reimburses medical expenses previously deducted in a tax return must be included in income, as this would otherwise result in a double tax benefit.
Wrongful Incarceration
Compensation for wrongful incarceration falls under a special category, as Congress has recognized the unique nature of these damages. The amounts received by wrongfully incarcerated individuals are excluded from income for federal tax purposes. This includes compensation for any physical injuries and non-physical injuries, such as emotional distress, suffered because of the incarceration.
Emotional Distress
Damages for emotional distress are taxable unless they are directly linked to a physical injury or physical sickness. This means that if emotional distress damages are awarded in connection with a lawsuit for physical injury, they are not taxable. However, if the emotional distress damages are standalone, without any accompanying physical injury, they are taxable.
Wrongful Death
The tax treatment of wrongful death awards varies depending on the composition of the award. Generally, amounts awarded that compensate for the decedent’s physical injuries or sickness are not taxable. However, punitive damages awarded in wrongful death cases are taxable, even though they may be part of the same lawsuit.
Employment Discrimination and Sexual Harassment
Settlements and awards for unlawful employment discrimination and sexual harassment can include various components, such as back pay, emotional distress, and punitive damages. Back pay is taxable as wages, while emotional distress damages not linked to physical injury or sickness are also taxable. Punitive damages, as mentioned earlier, are always taxable.
Punitive Damages
Punitive damages are awarded to punish the defendant for their actions and are always taxable to the recipient, regardless of the type of lawsuit. This is because punitive damages are not intended to compensate the plaintiff for lost income or expenses but rather to penalize the wrongdoer.
Egg Donor Pain and Suffering
Payments to egg donors for pain and suffering have been ruled taxable by the Tax Court. The court viewed these payments as compensation for services rendered, rather than tax-free damages for physical injury or sickness.
Interest
Interest received on any delayed settlement payments is taxable as interest income. This applies even if the underlying settlement amount is not taxable. The interest compensates the recipient for the time value of money lost due to the delay in payment.
Employer-Related Issues
Employers may deduct damages paid to employees for wrongful termination or discrimination as a business expense. However, the deductibility of these payments can be limited by various factors, including whether the payment is classified as a fine or penalty. Generally, fines and penalties paid to a government or specified nongovernmental entity for the violation of any law are not deductible for tax purposes. This includes amounts paid because of a conviction for a crime, amounts paid as penalties imposed by law in civil actions, and amounts paid in settlement of potential liability for fines or penalties, whether civil or criminal.
Injury to Capital and Lost Profits
Damages received for injury to capital, such as damage to property, or for lost profits are generally taxable. The rationale is that these damages replace income or assets that would have been taxable if not for the injury or loss.
Business-Related Damages
Damages received related to business interests, such as breach of contract, injury to capital, or lost profits, are generally taxable as ordinary income. This includes recoveries for lost profits or damages received because of a broken agreement to purchase property.
Deductibility of Attorney Fees
The deductibility of legal expenses hinges on the nature of the legal issue.
- Business or Employment-Related Legal Fees – Legal fees incurred in defending or filing damage suits related to a taxpayer’s business or employment are generally deductible. This includes defending against wrongful property claims, discrimination suits, or any legal action that could affect business operations.
- Personal Legal Fees – For personal lawsuits, such as those involving physical injury or wrongful incarceration, the associated legal fees are not deductible. However, specific exceptions exist, such as certain unlawful discrimination cases or whistleblower awards, where attorney fees may be deductible above the line, reducing your gross income.
- Changes in Deductibility Post-TCJA – The Tax Cuts and Jobs Act (TCJA) of 2017 brought significant changes to the deductibility of miscellaneous itemized deductions, including legal fees. From 2018 through 2025, miscellaneous itemized deductions, including legal fees for personal lawsuits, are suspended. This means that individuals cannot deduct these expenses, potentially increasing the tax burden on taxable damage awards or settlements. It isn’t uncommon for the award payment to be made to the attorney of the award recipient, with the attorney taking their fee from the payment and then issuing a check for the balance to the client. This does not mean that the award recipient need only pay tax on the net amount of the award. If the nature of the award is such that it is taxable, the entire amount of the award or settlement must be included in the recipient’s income. And as explained just above, the legal fees would not be deductible by the individual who received the award.
Out of Court Settlements
When a settlement occurs, especially in cases involving damages for personal injury or sickness, emotional distress, or other compensatory and punitive damages, the allocation of these damages is crucial for tax purposes. When a settlement is reached out of court and no specific allocation is mentioned in the settlement agreement, it is often necessary to refer to the original lawsuit to prorate the settlement between taxable and nontaxable amounts. This involves looking at the original claims and determining the proportion of the settlement that corresponds to each type of damage.
The taxation of damages and their deductibility by the payer is a nuanced area that requires careful consideration of the type of damages, the underlying cause of the legal action, and the specific components of any settlement or award. Both recipients and payers should be aware of the tax implications of any legal settlement or court award to ensure compliance with tax laws and to avoid unexpected tax liabilities.
Contact this office if you have questions or concerns about your specific circumstances. It is always prudent to understand the taxability so enough can be set aside from the award to pay federal and state (if applicable) income taxes.
