11.7 How Legal Damages Are Taxed
By statute, compensatory damages for physical injury or physical sickness are tax free, whether fixed by a court or in a negotiated settlement. Damages for nonphysical personal injuries, such as for discrimination, back pay, or injury to reputation, are taxable; a limited exception for certain emotional distress damages may be available as discussed below. Damages for lost profits, breach of contract, or interference with business operations are taxable. Interest added to an award is taxable, even if the award is tax-free damages for physical injury.
Emotional distress.
The law that provides an exclusion for damages received on account of a physical illness or sickness specifically provides that emotional distress by itself is not treated as a physical injury or sickness. To be tax free, damages for emotional distress must be attributable to a physical injury or sickness. For example, if you are injured in an accident and receive damages for emotional distress, or damages for emotional distress are included in the damages received in a wrongful death action, the emotional distress damages are tax free because they are deemed to be received “on account of” a physical injury; see Example 1 below.
If emotional distress damages are due to an injury other than a physical injury or sickness, as in a discrimination action, the damages are taxable with one exception: Damages up to the amount of actual medical care expenses attributable to emotional distress are tax free. That is, if you can prove actual expenditures for medical care to deal with emotional distress, that portion of the damages is tax free.
Apart from the medical expenses exception, damages for emotional distress are taxable when received for a personal injury other than a physical injury or sickness. Keep in mind that emotional distress, including its physical symptoms, is not treated as a physical injury or sickness, and so in an action for wrongful termination of employment or discrimination, emotional distress damages are taxable even where the damages cover physical symptoms of emotional distress such as insomnia, headaches, and stomach disorders. The Tax Court has held that depression falls within the category of emotional distress; see Example 2 below.
Caution
The National Taxpayer Advocate has argued that allowing tax-free treatment for emotional distress damages that are attributable to physical injury or sickness, but not non-physical injuries such as employer discrimination, is confusing and unfair. She has urged Congress to change the law and allow tax-free treatment for all awards for emotional distress, mental anguish, and pain and suffering.
Damages for wrongful termination.
If damages are received from a former employer for wrongful termination, the damages are usually taxable as compensation, but any amount for a workplace-related physical injury or illness are excludable from income. Unless the terms of a settlement or verdict specifically allocate damages to a physical illness or injury, it may be difficult to show that you are entitled to the exclusion. But the Tax Court was convinced in the following case.
Domeny was working as a fundraiser for nonprofit organizations when she was diagnosed with multiple sclerosis (MS) in 1996. She managed her symptoms without medication but in 2000 she took a job with an autism center where she could spend less time on her feet. The position involved fundraising, grant writing and community development. Domeny had a strained relationship with her supervisor, who restricted her duties. The stress caused her MS symptoms to flare up. In November 2004 she discovered that her supervisor was embezzling funds and she reported this to the center’s board of directors, who promised her that they would take action but did not. She felt uncomfortable about having to raise funds from parents while knowing that that her supervisor was embezzling funds. This situation continued for months, during which time her distress increased and her MS symptoms intensified. In March 2005, she went to her physician, complaining of vertigo, leg pain, numbness in both feet, burning behind her eyes and extreme fatigue. Her physician told her to stay home from work for two weeks but when Domeny notified the center, she was fired.
Domeny sued the center, alleging numerous discrimination and civil rights violations. The center agreed to settle and paid her a total of $33,308 of which $8,187.50 was treated as Form W-2 wages and $8,187.50 as attorney fees. The $16,933 balance was reported on Form 1099-MISC as nonemployee compensation. Domeny did not include the $16,933 on her 2005 return on the grounds that it was to compensate her for the worsening of her physical condition caused by working in a hostile work environment, and the fact that her condition prevented her from returning to work until more than a year after her termination.
The Tax Court agreed that the $16,933 payment was excludable from Domeny’s income. Even though the settlement agreement did not specify why the payment was made, the inference was clear that the center was recognizing Domeny’s complaint that a hostile and stressful work environment aggravated her physical illness. The fact that the settlement was segregated into three portions suggested that the center knew that part of the settlement was to compensate for physical illness. The center knew about Domeny’s illness before her termination, and her only claim was that she was fired after her work environment had caused the flareup in her MS symptoms.
Punitive damages.
Punitive damages are taxable, even if they relate to a physical injury or sickness. An exception in the law allows an exclusion from income for punitive damages awarded under a state wrongful death statute if the punitive damages are the only damages that may be awarded.
Holocaust restitution payments.
There is a broad exclusion from gross income for Holocaust restitution payments. Tax-free treatment applies to payments received by persons persecuted by Nazi Germany or any Nazi-controlled or allied country, as well as to payments received by heirs or estates of such persecuted persons. Persecution on the basis of race, religion, physical or mental disability, or sexual orientation is covered.
Excludable restitution includes compensation for assets that were stolen or lost before, during, or immediately after World War II and to life insurance issued by European insurers immediately before and during the war. Tax-free treatment also applies to interest earned on escrow accounts and funds established in settlement of Holocaust victim claims against European banks or corporations.
Legal fees.
If your damages are tax free, you may not deduct your litigation costs. If your damages are taxable, including the contingency fee portion of a taxable recovery (see below) you may be able to deduct your legal fees. A business expense deduction may be claimed on Schedule C for legal fees to recover taxable business income. An above-the-line deduction (directly from gross income) is allowed for legal fees in employment discrimination suits, certain other unlawful discrimination cases, and federal False Claims Act cases paid after October 22, 2004, with respect to settlements or judgments occurring after that date. The deduction cannot exceed the amount of the judgment or settlement you are including for the year. The above-the-line deduction is claimed on Line 36 of Form 1040 (12.2).
Legal fees not eligible for the above-the-line deduction or Schedule C deduction may be claimed only as miscellaneous itemized deductions on Schedule A subject to the 2% adjusted gross income floor (19.17). The miscellaneous itemized deduction is not allowed at all for alternative minimum tax (AMT) purposes.
Attorney’s contingent fee paid from taxable award.
If you receive taxable damages, such as back pay in an employment dispute, and a percentage goes directly to your attorney under a contingent fee agreement, can you exclude from your income the contingent fee payment, so that you are only taxed on the net amount you receive?
The answer from the Supreme Court is no. The Supreme Court held in its 2005 Banks decision that the contingency-fee portion of a taxable damages award or settlement generally must be included in the litigant’s gross income. The Court’s decision did not resolve whether attorney fees paid pursuant to a statutory fee-shifting provision must be included in income, but it suggested that such statutory fees might in some cases be excludable. However, a subsequent Tax Court decision held that the attorney-fee portion of a taxable settlement was includible in the litigant’s income where attorney fees were awarded under a California fee-shifting statute. Since the Supreme Court had not decided that issue, the Tax Court relied on its own prior decisions and precedent of the Ninth Circuit (where appeal would lie), which required inclusion of the fee portion of a settlement where a contingency-fee obligation was satisfied by a fee-shifting statute.
Note: If the contingency-fee portion of a taxable award in an unlawful employment discrimination case must be included in gross income under the Supreme Court decision, you may be able to offset the inclusion of the fees by an above-the-line deduction, as discussed above.