Tax Treatment of Settlement Awards and Damages

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Here’s a reminder on the tax treatment of damage or settlement awards: Proceeds received for physical injuries or physical illness are tax-free. On audit, IRS agents will look at the court petition, complaint, or claim that was filed, showing the original grounds for the lawsuit. They will review the settlement agreement to see how the document characterizes the amounts paid and received by the parties.

Damages received for emotional distress are taxable…with two exceptions. Amounts paid for mental anguish that arises from physical injuries are tax-free. The same goes for reimbursements for medical treatment of emotional trauma.

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Employment Dispute Settlement Award

Payments received in the settlement of an employment dispute are taxable. A man who was let go from his job filed a lawsuit claiming wrongful termination. The parties later settled, and he got about $70,000, with most of that attributed in the settlement agreement to emotional distress and relocation assistance.

According to the U.S. Ta x Court, the man credibly testified that he suffered physical and mental health injuries that he says were caused by his work. However, the Court decided the settlement proceeds were primarily paid to settle an employment dispute (Keenan, TC Bench Opinion).

This first appeared in The Kiplinger Tax Letter. It helps you navigate the complex world of tax by keeping you up-to-date on new and pending changes in tax laws, providing tips to lower your business and personal taxes, and forecasting what the White House and Congress might do with taxes. Get a free issue of The Kiplinger Tax Letter or subscribe.

Joy is an experienced CPA and tax attorney with an L.L.M. in Taxation from New York University School of Law. After many years working for big law and accounting firms, Joy saw the light and now puts her education, legal experience and in-depth knowledge of federal tax law to use writing for Kiplinger. She writes and edits The Kiplinger Tax Letter and contributes federal tax and retirement stories to kiplinger.com and Kiplinger’s Retirement Report. Her articles have been picked up by the Washington Post and other media outlets. Joy has also appeared as a tax expert in newspapers, on television and on radio discussing federal tax developments.