Do You Have to Pay Taxes on Out-of-Court Settlements?

Judges Gavel on Cash

Thousands of lawsuits settle out of court every year. These settlement agreements cover everything from slip and fall injuries to employment disputes. Figuring out whether you have to pay taxes on lawsuit settlements isn’t easy, or automatic. Here are some guidelines for what does, and does not, count as income.

Taxpayer’s Work Environment Forces Her to Leave

Cindy Stassi worked as a Human Resources Assistant at Vident, d.b.a. Vita North America, a dental device company, for three and a half years. Starting in February 2014, that employment did not go well. On February 4, 2014, she was diagnosed with shingles. A few months later her supervisor put her on a 30-day improvement plan. The next day she had a flare-up of her symptoms and went on an unpaid leave of absence.

On May 27, 2014, Ms. Stassi wrote a letter to the company’s board of directors complaining about her work environment. It didn’t mention her medical condition, but did describe specific problems with her employment. By December 12, 2014, the matter had escalated. Ms. Stassi had hired an employment lawyer who sent a second letter demanding damages for wage and hour violations, constructive termination, and “emotional distress and punitives.”

Ms. Stassi didn’t have to take her employment law complaints to court. She and her former employer settled out of court. On March 2, 2015, they entered into a settlement agreement awarding Ms. Stassi $80,000: $10,350 as “consideration for lost wages” and $69,650 as “consideration for physical manifestations of [Ms. Stassi’s] emotional distress claims.” Ms. Stassi got her two checks, as well as a Form W-2 for the wage portion and a Form 1099-MISC for the remaining nonemployee compensation.

Did the Employee Need to Report Her Non-Wage Income on her Tax Returns?

When the next tax season came around, Mr. and Ms. Stassi reported the W-2 wage income, and $1 of “Other Income” from the settlement proceeds. Their tax return preparer sent a statement to the IRS disclosing the $69,650 portion of the settlement agreement and explaining the decision not to include it as reportable income.

The IRS thought otherwise. It notified the Stassis they owed an additional $15,981 in income tax for 2015. Eventually, the Stassis asked the U.S. Tax Court to answer the question of whether the out-of-court settlement was taxable income.

This blog has covered whether lawsuit awards are taxable before. The U.S. Tax Code requires taxpayers to disclose and pay taxes on all income from any source unless it is covered by one of the particular exceptions included in the law. One of those exemptions is for damages received due to “personal physical injuries or physical sickness.” But emotional distress doesn’t count as a physical injury or illness. Where the IRS and the Stassis’ tax preparer disagreed was over whether “physical manifestations of emotional distress” were physical injuries or not.

Court Says Damages Were for Emotional Distress, Not Unreported Shingles

The answer to this question depended on exactly what Ms. Stassi’s attorney asked for in December 2014. The Court evaluated the nature of the specific claim underlying the out-of-court settlement. The Court noted that Ms. Stassi’s lawyer made no mention of her medical condition in the letter sent to the board. Instead, the claims were based in employment law. The words “physical manifestations” were added later. Because there was no causal link between Ms. Stassi’s workplace complaints and her medical condition, the Court said her settlement was for taxable emotional distress, rather than non-taxable personal injuries.

The distinctions drawn by the Court between physical manifestations of emotional distress and physical injuries excluded from the tax code may seem like a fine line. Clearly, sometimes tax preparers and the IRS can disagree on precisely where that line is. When a taxpayer’s sources of income include damages or an out-of-court settlement, it is wise to carefully review the agreement, and the reason for it with a tax attorney before filing a tax return.

Attorney Joseph R. Viola is a tax attorney in Philadelphia, Pennsylvania with over 30 years experience. If you have questions regarding IRS tax exemptions or need to refer your employment discrimination or personal injury client’s tax collections case, contact Joe Viola to schedule a consultation.