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.