If you are skilled and fortunate enough to get a nice monetary recovery for your client in an employment case, you need to understand what part of that recovery is taxable. From your client’s perspective, this issue will be critical.
When an employee sues an employer, the employee must report any part of a settlement or judgment that represents wages as gross income. IRC §61(a). By contract, any payments received by the employee due to personal physical injuries or physical sickness are excluded from gross income. IRC §104(a)(2). The tricky part is the mixed nature of claims in employment actions: as an attorney, you need to carefully examine the recovery to figure out which parts are includable in gross income (i.e., which are taxable) and which parts are excluded from gross income (i.e., which are nontaxable).
The tax treatment of employment recoveries is determined by a couple of things: (1) the character of the payment, and (2) the nature of the underlying claim.
The IRS looks at how the payments made in settlement or in satisfaction of judgment are characterized, i.e., as back pay, severance pay, compensatory damages. The IRS also considers the underlying claims made in an action so as to determine whether a payment is taxable as income to the employee. For example, the IRS analyzes whether a claim was made under any of the federal or state antidiscrimination, whistleblower, or civil rights statutes; whether the claim encompasses common law wrongful termination or other tort claims; or whether the claim encompasses breach of contract claims.
Here’s how it breaks down:
- Damages for wages or wagelike compensation (e.g., severance pay, front and back pay) are included in the employee’s income and subject to employment withholding and reporting requirements.
- Damages recovered for personal physical injuries or physical sickness are excluded from the employee’s income and are not subject to employment withholding and reporting requirements.
- Damages for other types of recoveries, such as punitive damages or emotional distress, are subject to income taxes but not employment taxes.
As a general rule, most employment-related recoveries are included in the employee’s gross income, unless a cause of action has its origin in a physical injury or physical sickness, in which case all damages (other than punitive damages) that flow from it are treated as payments received on account of physical injury or physical sickness whether or not the recipient of the damages is the injured party. For example, damages received by a third party on account of loss of consortium due to the physical injury or physical sickness of the third party’s spouse are excludable from gross income. H Rep No. 737, 104th Cong., 2d Sess. (1996), 96 US Code Cong & Ad News 1677, 1793.
But be warned, the rules for determining whether and how much of a recovery is actually on account of physical injury or physical sickness can be complicated to apply in specific cases.
For everything you need to know about the taxation of judgments and settlements in employment cases, turn to CEB’s Employment Damages and Remedies, chap 9. This is the newest book in CEB’s OnLAW Employment Law Library, a virtual encyclopedia of employment law.
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