Have a general question about employment law? Want to share a story? I welcome all comments and questions. I can't give legal advice here about specific situations but will be glad to discuss general issues and try to point you in the right direction. If you need legal advice, contact an employment lawyer in your state. Remember, anything you post here will be seen publicly, and I will comment publicly on it. It will not be confidential. Govern yourself accordingly. If you want to communicate with me confidentially as Donna Ballman, Florida lawyer rather than as Donna Ballman, blogger, my firm's website is here.

Friday, January 6, 2012

Will I Be Taxed on My Employment Law Settlement?

There’s nothing certain in life but death and taxes. So what made you think you wouldn’t be taxed on your employment law settlement? I ask people this all the time when they express absolute shock that taxes were withheld from their severance check and that they’ll get hit with a tax bill in April on their emotional distress damages.

            It’s not for lack of trying. Employment lawyers and advocacy groups on both sides of the aisle have been trying for years to get the Civil Rights Tax Relief Act passed, and 2011 was no exception. It was reintroduced in the Senate on November 2, 2011 to match the House version that was introduced in October.

            Right now, the law says that, if you are injured in a car accident or have another personal injury, your settlement or judgment isn’t taxable at all. However, if you’re the victim of discrimination and suffer emotional distress, you are taxed. You also can’t average the income, so you can be taxed at a very high rate. 

            Here are the types of recovery you might receive in your employment case, and how IRS looks at it.

            Back pay: You will be taxed. Payroll taxes must be withheld. You are taxed at a “supplemental wage rate.” It’s reported on a W-2. If the Civil Rights Tax Relief Act passes, multi-year back pay could be averaged over several years for tax purposes, lessening the tax hit.

            Front pay/future lost wages: You will be taxed. Payroll taxes must be withheld. You are taxed at a “supplemental wage rate.” It’s reported on a W-2. If the Civil Rights Tax Relief Act passes, multi-year front pay or future lost wage payments could be averaged over several years for tax purposes, lessening the tax hit.

            Severance: You will be taxed. Payroll taxes must be withheld. You are taxed at a “supplemental wage rate.” It’s reported on a W-2. If the Civil Rights Tax Relief Act passes, multi-year severance payments could be averaged over several years for tax purposes, lessening the tax hit.

            Emotional distress: Even if there are physical symptoms, you will be taxed. However, you don’t have payroll taxes withheld. The danger here is you’ll get hit with a big tax bill in April and, if you don’t put a big chunk of money aside to pay, you’ll be in trouble with the IRS. The employer has to report this payment to IRS, so you will definitely have to pay. It’s reported on a 1099-MISC. If the Civil Rights Tax Relief Act passes, emotional distress damages would no longer be taxable or reported as income to IRS. They would be treated similarly to physical injuries..

            Physical injuries: If you’re actually attacked, such as in a sexual harassment case with a rape, then money received for your physical injuries is not taxable income. However, if you mischaracterize emotional distress injuries as physical injuries, you could run into trouble in an audit. It is not reported to IRS.

            Liquidated damages: You will be taxed, but they are not wages. They will be reported to IRS on form 1099-MISC.

            Attorney’s fees: Attorney’s fees paid in your settlement are income to you, but are not wages. These will be reported as income to your attorney and you. However, under an earlier iteration of the Civil Rights Tax Relief Act where Congress only passed the portion addressing attorney’s fees, the fees are an above-the-line deduction for you in most employment law cases. In other words, you have to report them, but you won’t be taxed on them. This is something you need to discuss with whoever is preparing your tax return and make sure they understand it.

            Costs: Taxable but not wages. These are reported to IRS on 1099-MISC. You will be taxed on them, although they may be deductible.

            Interest: Taxable but not wages. This is reported to IRS on 1099-INT. Interest is taxable.

            Punitive damages: This is taxable but not wages. It will be reported on 1099-MISC.

            Overtime: Overtime payments will be taxed as wages. That means payroll taxes will be withheld and it will be reported to IRS on a W-2. If the Civil Rights Tax Relief Act passes, multi-year overtime payments could be averaged over several years for tax purposes, lessening the tax hit.

            Taxes: One solution that lawyers have negotiated in some large settlements involving back pay that represents years of income is to have the employer pay part of the employee’s tax hit that results from a lump sum payment. But the payment towards taxes is considered taxable wages. It will be reported on a W-2. This would no longer be necessary if the Civil Rights Tax Relief Act passes.

            Because the Civil Rights Tax Relief Act has been attempted and failed so many times, I’m not optimistic that it will pass anytime soon. Yet both employee-side organizations and business organizations support it. Both sides agree that it will make cases easier to settle, which means that litigation costs will go down. The courts will be less clogged. It will be good for just about everyone. 

            Maybe sometime before I retire this sensible bill will pass. If you think it’s a good idea, contact your Senator and Congressional representative and ask them to support the Civil Rights Tax Relief Act.


  1. Donna,
    my virus program declares your site as being a malicious threat to computers.

  2. Hi Griper. Thanks for telling me about this. Can you copy and paste the error message? The problem is triggered by comments that have spam links. Google Chrome alerts if there are links to malicious sites. I'll need to comb through my site and find it. The error message will help me. In the meantime, the site is safe - just don't click on any links in comments.

  3. here is what i get, Donna. hope you can find it.

    URL: http://www.mmmglawblog.com/favicon.ico
    Process: file://C:\Program Files\AVAST Software\A...
    Infection: al

    btw, it alerts me as i enter your site.

  4. Thanks Griper. Can you try it again? I think I found the offender.

  5. mmm nope, still pops up when i comment here.

  6. Took me awhile but I think I have it now. Without your error message I'd have never found it, so you're a lifesaver! If I'm right, it was a link in my blogroll. Let me know if you get a chance to check again.

    Thanks so much for your help.

  7. think you got it this time, Donna. no warning popped up when entering you site.

    and it is a pleasure to help. hope we caught it in time to not scare anybody away from here.

  8. Truly appreciated Griper. You're a gentleman and a scholar.

  9. Donna, found an article that you might be interested in if you haven't already seen it.
    employee discrimination by churches

  10. Thanks Griper! That's a big new case from the Supreme Court. I was writing an article about it, so this helped. Much appreciated.

  11. Lets say someone received a sum from an employment settlement. A small amount was subject to tax withholding and reported on a W-2.
    Question 1- What is employer suppose to withhold and not withhold on the W-2?
    Questions 2- The other amount was compensatory damages (emotional distress) non injury related, that will be reported on a 1099 and the client is stuck with a BIG hit on paying taxes correct?
    Questions3- does that settlement affect the tax bracket if the employee worked in the year of 2011, is it added to the individual taxes?
    Questions 4- any suggestions, tips, advice, etc to help with the tax burden?
    Thank you so much!!!!!

    1. I have the same issue emotion distress, back pay, on the job injury, discrimination the company didn't report it to on my w-2 form, only a small amount, can the company do that

  12. Hi stuckontaxes! I'm definitely not a tax lawyer, but here's an IRS memo that I think explains and answers your questions: http://www.irs.gov/pub/lanoa/pmta2009-035.pdf

    It's about as clear as mud, I know. I'd suggest talking to your accountant for any additional advice.

  13. Please advise. I am 61 and worked for my company for 8 years. I was misclassified as an Independent Contractor and paid by 1099. I fell at work and they had no workers comp. I am in Texas. I am on SS Dissability and cannot work. I sued the company for unpaid overtime in Federal Court. We settled today. I know that I have to pay income taxes. My question is how do they pay me correctly, by W2 or by 1099? I want to make certain it is done correctly, because they are greedy and will always do the wrong thing! Please advise.
    Karen Sand
    469 693-7457


I appreciate your comments and general questions but this isn't the place to ask confidential legal questions. If you need an employee-side employment lawyer, try http://exchange.nela.org/findalawyer to locate one in your state.