Are Employee Settlements Taxable?If you are successful in an employment case, you might settle with your employer for a sum of money. But how much of it can you keep and how much will you lose in taxes?

Uncle Sam will come knocking, expecting a cut of the proceeds, so you and your attorney should discuss ahead of time how much you can expect to pay in taxes.

Nearly all Employment Settlements are Taxable

Generally, you must pay taxes on most employment settlements, including settlements related to the following:

  • Back wages
  • Punitive or liquidated damages
  • Front pay
  • Interest awards
  • Emotional distress awards

There are only a couple exceptions for payments related to the following, which will not count as taxable income:

  • Certain attorneys’ fees
  • Payments that compensate for damages as a result of physical injuries or physical sickness

Consider the following: Melissa is sexually assaulted by a supervisor, suffering physical injuries. After the assault, she reaches a settlement for a sum of money that pays for medical treatment, emotional distress, and lost wages. Because all of these losses stemmed from “physical injuries” perpetrated by the assault, Melissa can exclude all of them from her income tax.

However, if Melissa had not been physically injured—but had instead endured catcalls and lewd jokes—then she cannot exclude her settlement from her taxable income.

Allocate Settlement Proceeds in the Settlement Agreement

You might receive a lump sum of money for a variety of losses. Some of these losses might be the result of physical injuries and thus excludable for income tax purposes. However, other losses might not be the result of physical injuries and therefore must be included in your income for tax purposes. If you get $50,000 in the settlement, how much of that amount do you count as taxable?

According to the IRS, you have the burden of showing that settlement proceeds are excludable from your taxable income. One way to handle this is to have the settlement agreement explicitly state how much of the settlement is for losses on account of physical injuries or physical sickness and how much isn’t. A settlement agreement allocation is usually dispositive for this inquiry.

Withholding and Reporting Provisions Apply

All settlement proceeds must be reported to the IRS using the appropriate form:

  • Form W-2: to report proceeds meant to compensate for wages.
  • Form 1099-MISC: to report all non-wages as “other income.”

Furthermore, your employer must deduct Social Security and Medicare taxes from any proceeds meant to compensate for wages and send to the IRS. Some employees want to classify all proceeds as “other income” to avoid withholding taxes, but this is not a good strategy since it opens up the employer and employee to potential legal liability.

Speak with an Employment Attorney in California

Employment settlements raise complicated tax issues. For more information about how an attorney can help with the settlement process, please contact the Workplace Rights Law Group today. We can analyze your case and advise you about the best way to proceed. Contact us today for your free case review.


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