Tax Consequences of Settlement Awards

A recent column in the New York Times argues that some settlements – including billion dollar mortgage fraud settlements – can actually benefit the banks because they may be tax deductible as a business expense. This applies to employment law settlements as well – if a company settles a multi-million dollar race discrimination suit, that settlement can be deducted. Sadly, the reverse is true for the victimized employee. Any settlement money received in a wage or discrimination case must be declared on the employee’s taxes as “income.” This is true for all settlement money that is intended to compensate the employee for wages or compensation, pain and suffering (emotional distress or anguish). This is true even for punitive damages – despite the fact that the whole point of punitive damages is that it is not intended to compensate the victim so much as to punish the company. The only exception to the taxability of settlements is where the employee has suffered emotional distress as a result of physical injuries or sickness caused by the employer, as the Supreme Court decided here and here.

There is one bright spot for employees who succeed in wresting money from their former employers for their unlawful activity. The Tax Code (62(a)(20)) allows individuals to deduct the attorneys’ fees paid for claims relating to unlawful discrimination, the enforcement of civil rights, unlawful retaliation, whistleblowing; and compensation.

It is a topsy turvy world where an employer gets a tax benefits for the money paid to an employee in settlements or judgments for its unlawful conduct, but the employee must pay a good share of his or her recovery to the government.