Friday, August 5, 2016

How Are Settlements Made on Employment Discrimination Claims Taxed?

Should the Settlement Paid on My Discrimination Claim be Subjected to Withholding and Taxes? 

DISCLAIMER:  I am NOT a licensed tax attorney; I have never received any formal training relating to the Internal Revenue Code or any topic raised herein.  This Post is based solely upon my interpretation of the cases and statutes discussed herein.  You should NOT rely upon this Blog Post in any way, and should instead retain a licensed tax professional if you require guidance as to any issue discussed below.

Settlements Paying Lost Wages to
Discrimination Victims Taxable
The IRS has made clear that a plaintiff bringing a claim under federal anti-discrimination statutes such as Title VII, the Pregnancy Discrimination Act, the Americans With Disabilities Act or the Age Discrimination in Employment Act must pay ordinary withholding and taxes on any part of a settlement or judgment paid to the plaintiff that is intended to compensate he/she for lost wages.


But, how about any portion of such a settlement that is intended to compensate the plaintiff for his/her emotional distress?  Unfortunately, it appears that such compensation is also to be treated as ordinary W-2 income. 

NOTE:  Settlements or judgments paid to a plaintiff who has brought a claim under the Family and Medical Leave Act of 1993 may NOT be subject to taxation.

FMLA Claims Subject to Different,
Possibly More Favorable Tax Treatment

Settlements Paid Out on Claims for Lost Wages and Compensation Made Under Anti-Discrimination Laws Such as Title VII Are Treated as Ordinary Income and Subject to Withholding and Taxes and are Paid as W-2 Income Just Like a Regular Employee Paycheck

Any portion of a settlement or judgment paid to compensate a plaintiff for lost wages on a claim made pursuant to anti-discrimination laws such as Title VII, the Americans With Disabilities Act and the Age Discrimination in Employment Act is to be treated as “ordinary income.”

Settlement Check Looks Just Like Regular Paycheck -
Although Hopefully LOT Bigger!
Hence, any such recovery is paid out like a regular paycheck, i.e. reduced by FICA, state and local tax obligations, as well as required contributions to Social Security and Medicare. As per  Publication 4345 (Rev. 4-2015) 

Lost wages or lost profits

•      If you receive a settlement in an employment-related lawsuit; for example, for unlawful discrimination or involuntary termination, the portion of the proceeds that is for lost wages (i.e., severance pay, back pay, front pay) is taxable wages and subject to the social security wage base and social security and Medicare tax rates in effect in the year paid. These proceeds are subject to employment tax withholding by the payor and should be reported by you as ‘Wages, salaries, tips, etc.” on line 7 of Form 1040.

This comes to a surprise to many of my clients, and perhaps understandably so.  That is due to the widespread understanding that recoveries made on personal injury claims are by and large tax free. As per the same Publication 4345:

Personal physical injuries or physical sickness

•     If you receive a settlement for personal physical injuries or physical sickness and did not take an itemized deduction for medical expenses related to the injury or sickness in prior years, the full amount is non-taxable. Do not include the settlement proceeds in your income. BUT [portion discussing medical expenses omitted]…
                                 .                      .                         .
Emotional distress or mental anguish

•     The proceeds you receive for emotional distress or mental anguish originating from a personal physical injury or physical sickness are treated the same as proceeds received for Personal physical injuries or physical sickness above.

If I Sue for Discrimination and Some of the Settlement or Judgment is Intended to Compensate me for Emotional Distress, is That Part of my Recovery Taxable Like Ordinary Income?

Any employment-related claim will virtually always include a claim for emotional distress. That is so because a loss of employment resulting from illegal employment practices is not only damaging to an individual’s feelings of self-worth, but also to one’s financial stability. 

Victims of Discriminatory Termination Often
Suffer Great Emotional Distress
It is axiomatic that when conscientious human beinG's with ordinary obligations are separated from employment through no fault of their own, great psychological pain almost always surfaces, and endures. When the root cause of the separation was an immutable human characteristic such as an individual’s sex, color, national origin, age, disability or religious beliefs, it stands to reason that the pain is exponentially greater. 

The pain caused by such insults to one’s self-esteem, reputation and social standing are in all such cases exacerbated further by the anguish that inevitably results when one no longer has sufficient financial means to meet his/her living expenses. 

Hence, whenever I settle a claim for loss of employment resulting from unlawful employment practices, I always seek and recover some compensation for my client’s emotional harm.  Indeed, in many cases, a significant portion of the settlement paid on a discrimination claim is intended to compensate the plaintiff for such emotional distress.

Logic dictates, at least in my view, that damages in the form of mental/psychological pain are in essence personal injuries and, if a personal injury plaintiff’s recovery for such damages is not taxable, the very same should be true for victims of unlawful employment practices. 

The Majority View is That All Portions of a Settlement Paid on Employment-Related Claims Such as Race, Sex, Age or Disability Discrimination, are Subject to Ordinary Withholding and Taxation and Should be Paid Out as W-2 Income

The way I read the Publication 4345, the only part of a settlement received in an employment-related claim that is subject to withholding and taxes is “the portion of the proceeds that is for lost wages (i.e., severance pay, back pay, front pay).”  I believe my reading is supported not only by the plain words in the Publication, but also by the absence of any suggestion to the contrary therein.


The Final Word:
All Settlement Proceeds on Employment-Related Claims
May be Taxable as Ordinary Income
Alas, the IRS may see things differently.



IRC §104(a)(2), (entitled “Compensation for injuries or sickness”), provides that only proceeds paid to a litigant “on account of personal physical injuries or physical sickness” are entitled to tax free recovery. 

The Code of Federal Regulations, which are administrative regulations published by the executive departments and agencies of the federal government in order to explain federal statutes, specifies that “[e]motional distress is not considered a physical injury or physical sickness [unless such distress is] attributable to a physical injury or physical sickness.”   

Based upon these provisions, numerous commentators, including the American Bar Association, have concluded that all portions of a settlement or judgment paid out to a plaintiff making an employment-related claim are subject to ordinary withholding and taxes.

Insofar as I am aware, the United States Supreme Court has yet to specifically address this issue. Unless and until it does, it appears that the most prudent course is to treat all portions of a settlement or judgment received by a plaintiff making an employment-related claim exactly the same as the paycheck said plaintiff once earned while employed by the former employer he/she has sued.  


At Least...
Attorneys Fees Not Taxable to Plaintiff
NOTE:  Any portion of a settlement or judgment that is payable to the plaintiff’s attorney is not taxable to the plaintiff. 



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