Are Employment Settlements and Awards Taxable?

Mostly yes. Under federal tax law, the exclusion for damages in 26 U.S.C. § 104(a)(2) covers those received "on account of personal physical injuries or physical sickness," and the statute says emotional distress is not treated as a physical injury or physical sickness.⁠^[1] Lost wages, emotional distress payments, punitive damages and interest in an employment case are therefore generally taxable.⁠^[7][2][3]

This page is general information about federal tax rules, not tax advice. It does not cover New York State or New York City income tax. A tax professional can apply the rules to a specific settlement or award.

Does it matter whether the money comes from a settlement or a court award?

Not for the basic rule. The exclusion in 26 U.S.C. § 104(a)(2) applies to qualifying damages "whether by suit or agreement and whether as lump sums or as periodic payments."⁠^[1] What matters is what the payment is for. The deduction for legal fees discussed below is written to reach claims under federal, State or local law providing for the enforcement of civil rights or regulating the employment relationship.⁠^[5]

How is each part of a recovery treated?

Component	Federal tax treatment
Lost wages: back pay, front pay, severance pay	Taxable wages, subject to Social Security and Medicare taxes at the rates in effect in the year paid and to employment tax withholding by the payer.⁠[2]
Emotional distress or mental anguish not originating from a physical injury or physical sickness	Included in income, reduced by certain medical expenses for the distress.⁠[7]
Damages on account of personal physical injuries or physical sickness (other than punitive damages)	Excluded from gross income.⁠[1]
Punitive damages	Taxable, even when received in a settlement for personal physical injuries or physical sickness.⁠[3]
Interest on a settlement	Generally taxable as interest income.⁠[3]
The share paid to the lawyer as a contingent fee	Generally part of the client's income when the recovery is income; a deduction is available in unlawful discrimination cases.⁠[4][5]

Why isn't a discrimination or harassment settlement tax-free?

A common belief is that money paid for a legal injury is not income. The tax code draws a narrower line. Section 104(a)(2) excludes damages, other than punitive damages, received on account of personal physical injuries or physical sickness.⁠^[1] The same section then says that, for this purpose, "emotional distress shall not be treated as a physical injury or physical sickness."⁠^[1]

Payments for lost pay, and payments for emotional harm that does not originate from a physical injury or physical sickness, fall on the taxable side of that line.⁠^[7][2]

How are emotional distress payments taxed?

The IRS's public guidance, Publication 4345, states that if the proceeds received for emotional distress or mental anguish do not originate from a personal physical injury or physical sickness, the recipient must include them in income.⁠^[7]

There is one statutory adjustment for medical costs. The rule treating emotional distress as non-physical does not apply to an amount of damages not in excess of the amount paid for medical care attributable to emotional distress.⁠^[1] The IRS describes the result this way: the amount included in income is reduced by amounts paid for medical expenses attributable to the emotional distress that were not previously deducted, and by previously deducted medical expenses for it that did not provide a tax benefit.⁠^[7]

As a practical matter, that makes receipts and statements for therapy, medication and other treatment worth keeping. The guide to emotional distress damages explains how this kind of harm is proved in the case itself.

How are lost wages taxed?

The IRS treats them as wages. Publication 4345 says that in a settlement of an employment-related lawsuit, "for example, for unlawful discrimination or involuntary termination," the portion of the proceeds that is for lost wages (severance pay, back pay, front pay) is taxable wages.⁠^[2] That portion is subject to the Social Security wage base and to the Social Security and Medicare tax rates in effect in the year paid, and the proceeds are subject to employment tax withholding by the payer.⁠^[2]

Which information-return forms a payer issues for each part of a settlement is not covered here. How lost pay is measured is covered in back pay, front pay and reinstatement.

What about punitive damages and interest?

Both are taxable. The IRS states that punitive damages are taxable and are reported as other income, even if they were received in a settlement for personal physical injuries or physical sickness.⁠^[3] Interest on a settlement is generally taxable as interest income.⁠^[3] The standards for awarding punitive damages are in the guide to punitive damages in New York employment cases.

Are you taxed on the part that goes to your lawyer?

This question has two steps.

1. The fee is generally counted as the client's income. In Commissioner v. Banks (2005), the Supreme Court held that, as a general rule, when a litigant's recovery constitutes income, the litigant's income includes the portion of the recovery paid to the attorney as a contingent fee.⁠^[4]
2. A deduction is available in discrimination and employment cases. Under 26 U.S.C. § 62(a)(20), a taxpayer may deduct, in computing adjusted gross income, attorney fees and court costs paid in connection with any action involving a claim of unlawful discrimination.⁠^[5]

The deduction has a ceiling. It does not apply to any amount in excess of what is includible in the taxpayer's gross income for the taxable year on account of the judgment or settlement resulting from the claim.⁠^[5] Because the ceiling is measured by the taxable year, the timing of fee payments and settlement payments is a point to raise with a tax professional.

The definition of "unlawful discrimination" in the tax code is broad. It includes acts unlawful under any federal, state or local law providing for the enforcement of civil rights, or regulating any aspect of the employment relationship, including laws prohibiting the discharge of an employee, discrimination against an employee, or any other form of retaliation or reprisal against an employee for asserting rights.⁠^[5]

For the separate question of when the other side can be ordered to pay fees, see attorney's fee awards in New York employment cases. For how lawyers charge, see contingency fees.

Does the wording of the settlement agreement matter?

It can. The IRS notes that a settlement payment may consist of multiple elements that have been allocated by the parties, and gives the example of an agreement with allocations to back pay, emotional distress and attorneys' fees.⁠^[3] Generally, the IRS will not disturb an allocation if it is consistent with the substance of the settled claims.⁠^[3]

Note the qualifier: the IRS's statement is limited to allocations that are consistent with the substance of the settled claims.⁠^[3] What a release and its other terms mean is covered in severance agreements and releases.

How does a nondisclosure clause affect taxes in a sexual harassment settlement?

The rule here is about the employer's taxes. Under 26 U.S.C. § 162(q), no business deduction is allowed for any settlement or payment related to sexual harassment or sexual abuse if the settlement or payment is subject to a nondisclosure agreement, or for attorney's fees related to such a settlement or payment.⁠^[6]

The IRS has addressed whether that rule also reaches the person who receives the payment. Its answer is that recipients of such settlements are not precluded by section 162(q) from deducting attorney's fees related to the settlement or payment, if otherwise deductible.⁠^[8]

Tax law is not the only limit on confidentiality terms. Under New York State's General Obligations Law § 5-336, the complainant has up to 21 days to consider a term preventing disclosure of the underlying facts of a discrimination claim and at least seven days after signing to revoke the agreement.⁠^[9] The guide to nondisclosure agreements in sexual harassment cases covers those rules.

What people commonly get wrong

• "Discrimination settlements are tax-free." The exclusion covers damages on account of personal physical injuries or physical sickness, and emotional distress is not treated as either.⁠^[1]
• "Punitive damages are tax-free if the case involved a physical injury." The IRS says punitive damages are taxable even then.⁠^[3]
• "I am only taxed on what I actually receive after my lawyer is paid." The fee portion is generally part of the client's income; a deduction for unlawful discrimination claims is available, up to the amount included in income for the year from the judgment or settlement.⁠^[4][5]
• "The agreement can call the money anything." The IRS's stated practice is to respect allocations that are consistent with the substance of the settled claims.⁠^[3]

Questions to take to a tax professional

• How is each payment in the agreement described, and does that description match what the claims were about? The IRS generally will not disturb an allocation that is consistent with the substance of the settled claims.⁠^[3]
• In which tax year will each payment arrive, and in which year are the legal fees paid?
• Which treatment costs for emotional distress were paid, and were any of them deducted in earlier years?
• How do New York State and, for City residents, New York City income taxes apply? This page does not cover them.

Taxes are one of several things that affect what a person keeps from a recovery. See what a New York employment case can recover and what goes into the value of a claim.