Obtaining a courtroom victory or agreeing to a cash settlement can create a huge windfall for the recipient. This isn’t something that is comparable to winning the lottery since lawsuits and settlements often arise out of someone filing a claim of action due to wrongful death, personal injury or some other major loss. The general purpose of the litigation is to make someone whole again after a serious catastrophe. One of the first questions asked by the recipient after the big win is “do I have to pay taxes on this?”. The answer, in true and frustrating lawyer fashion, is “it depends.”
Generally, taxable gross income does not include “the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness.” 26 U.S.C. 104(a)(2). The following types of lawsuits that are considered “personal physical injuries or physical sickness” include, but are not limited to:
- Torts that result in individual physical injuries such as assault and battery, automobile collisions, slip-and-fall from negligently maintained premises and workplace hazards.
- Physical injuries and illness from product-liability lawsuits (e.g. contaminated food or medication, malfunctioning motor vehicles, etc.)
- Wrongful death lawsuits, since the damages are imposed due to verdict or settlement that a third party is responsible for the physical illness or injury that resulted in death.
The following types of lawsuits that are NOT considered “personal physical injuries or physical sickness” include, but are not limited to:
- NON-PERSONAL INJURY OR SICKNESS TORTS: The requirement of personal injury or sickness exclude other torts relating to property or business dealings such as trespass, conversion, fraud, misrepresentation, and tortious interference with contractual obligations.
- EMOTIONAL DISTRESS: Emotional distress “shall not be treated as a physical injury or physical sickness” for the purposes of taxable income exclusion. 26 U.S.C. 104(a). As a result, recoveries for personal injuries related to mental pain and anguish or injury to professional reputation are not excluded from tax. Murphy v. IRS, 493 F.3d 170 (D.C. Cir. 2007). However, if the emotional distress recovery is on account of the personal physical injuries or sickness sustained, then it may be excludible (e.g. insomnia, headaches and stomach disorders). Any amount of emotional distress medical care paid in excess of 10% of the taxpayer’s gross income may be an itemized deduction on Schedule A. 26 U.S.C. 213(a). Any amounts of medical care paid under the 10% threshold are excludable from taxable income, whether paid for physical or emotional treatment. 26 U.S.C. 104(a). “Medical care” that is excludable includes amounts paid “for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body” and transportation for these purposes. 26 U.S.C. 213(d)(1)(A-B).
- EMPLOYMENT-RELATED SUITS: Any compensatory damages for wrongful discharge or failure to honor contract obligations in the course of employment (including awards or settlements for lost wages, business income and benefits) are fully taxable UNLESS any amounts are for compensatory damages for a personal physical injury or physical sickness sustained during the course of employment.
- DISCRIMINATION SUITS: Any compensatory damages arising out of discrimination lawsuits on the basis of age, race, gender, religion or disability are fully taxable.
- DEFAMATION: Any compensatory and putative damages arising from libel and slander lawsuits are fully taxable. Lindsey v. Commissioner, T.C. Memo 2004-113, aff’d, 422 F.3d 684 (8th Cir. 2005).
The Small Business Job Protection Act of 1996 explicitly amended 26 U.S.C. 104(a)(2) to include the word “physical” to recover on personal injuries or sickness. In addition, a business entity is not capable of suffering a physical injury or sickness, so the taxable income exclusion for lawsuits and settlements is only applicable to individuals. P & X Markets, Inc. v. Commissioner, 106 T.C. 441 (1996), aff’d in unpublished order, P & X Markets, Inc. v. Commissioner, 139 F.3d 907 (9th Cir. 1988).
The general understanding is that the nontaxable amount of damages applies to the “compensatory damages”, meaning the amount paid to the taxpayer for a loss to restore him or her to pre-injury status. However, courts may add “punitive damages” on top of the compensatory damage award as a penalty to the defendant for acting intentionally, maliciously or recklessly. These awards are meant to function as a civil fine and deter similar behavior from others in the future. As a rule, punitive damages awarded are not excludible from taxable income.
However, the phrase “other than punitive damages” in 26 U.S.C. 104(a)(2) does NOT apply to the following punitive damages awarded in a civil action:
- Those awarded in a wrongful death action. 26 U.S.C. 104(c)(1).
- Those civil actions in which state law or a ruling by a competent court in that state (as in effect on September 13th, 1995) provides that ONLY putative damages may be awarded in such an action. 26 U.S.C. 104(c)(2).
If damages are awarded after a verdict, the judge or jury will generally delineate which amounts are attributable to compensatory damages and which amounts are attributable to punitive damages. This separation gets more complicated in an out-of-court settlement where the parties may not necessarily classify the amounts agreed upon. The general rule is that the nature of the claim for settlement controls whether such damages are excludable under 26 U.S.C. 104(a)(2). Even if the parties have a written agreement that outlines the damages classification, the Internal Revenue Service may determine that some, if not all, of the award is not excludable from tax because the underlying claim was for non-physical injuries and sickness or that some of the settlement amount is really punitive damages in excess of the plaintiff’s actual injuries sustained. The IRS can make a reallocation of the settlement award if it believes that “the allocation did not accurately reflect the realities of the petitioner’s underlying claims.” LeFleur v. Commissioner, T.C. Memo. 1997-312, 10.
Here are some other details related to the taxability of lawsuit awards and settlements:
- LOST WAGES AND BACK PAY: Generally speaking, any judgment or settlement (whether from a physical or non-physical injury or sickness) will have those portions attributable to lost wages, back pay and forward pay subject to federal taxation. In addition to federal income tax, the portion of the judgment or settlement that is wage-related may be subject to the Federal Insurance Contributions Act (FICA), Federal Unemployment Tax Act (FUTA) and income tax withholding. If a judgment or settlement is not considered includable in gross income, then it is not generally subject to employment taxes. In addition, legally designated interest, attorney fees and liquidated damages in the settlement award may not be considered wages for federal employment tax purposes.
- ATTORNEY’S FEES: When the ultimate settlement or judgment award is excludable from gross income, either in whole or in part, the payment of contingent attorney’s fees allocable to exempt income are NOT deductible. 26 U.S.C. §265(a)(1). Taxpayers were previously allowed to deduct attorney fees from settlements and judgments if it generated taxable income (e.g. putative damages) if he or she listed these expenses as a miscellaneous itemized deduction on Schedule A. If the settlement or judgment was mixed as partly compensatory and partly putative, then the attorney fees were allocable by proportion to the taxable and non-taxable portions. However, the Tax Cuts and Jobs Act of 2017 suspends miscellaneous itemized deductions for tax years from January 1st, 2018 to December 31st, 2025, so taxpayers cannot deduct legal expenses relating to personal legal matters during this time.
- INTEREST: Several states, including Michigan, have statutes that require defendants to pay accrued interest on judgments in civil actions. This interest is always taxable no matter what the nature of the settlement or award is. Kovacs v. Commissioner, 100 T.C. 124, aff’d, 25 F.3d 1048, cert. denied, 513 U.S. 963 (1993).
There is no one-size-fits-all answer for the tax consequences of a judgment or settlement and any recipient of such an award is well-advised to seek the advice of a knowledgeable tax professional. If you have tax questions about your settlement or judgment, do not hesitate to contact the lawyers at Kershaw, Vititoe & Jedinak PLC today.