The fundamental principle governing the taxability of funds received from the resolution of legal disputes, including lawsuits, adheres to Internal Revenue Code (IRC) Section 61. This section stipulates that all income is subject to taxation unless specifically exempted by another section of the code. IRC Section 104 provides an exemption from taxable income concerning lawsuits, settlements, and awards. However, it’s imperative to assess the circumstances surrounding each settlement payment to ascertain the purpose for which the money was received since not all settlement amounts are exempt from taxes. The pivotal question is: “What was the settlement intended to compensate for?”
IRC Section 61 outlines that all amounts from any source are considered part of gross income unless a distinct exception exists. For damages, the two primary exceptions are amounts paid for specific discrimination claims and amounts paid due to physical injury.
IRC Section 104 explains that gross income excludes damages received on account of physical injuries. IRC Section 104(a)(2) allows taxpayers to exclude from gross income “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 injuries or physical sickness.
Regulation Section 1.104-1(c) defines damages received on account of personal physical injuries or physical sickness as an amount received (other than workers’ compensation) through the prosecution of a legal suit or action, or through a settlement agreement entered into instead of prosecution.
Awards and settlements can be categorized into two groups to determine their taxability: claims related to physical injuries and claims related to non-physical injuries. The IRS consistently asserts that compensatory damages, including lost wages, received on account of personal physical injury are excluded from gross income, with the exception of punitive damages.
Damages received for non-physical injuries such as emotional distress, defamation, and humiliation, while generally part of gross income, are not subject to Federal employment taxes. Mental and emotional distress arising from non-physical injuries is only excluded from gross income if received on account of physical injury or physical sickness.
Punitive damages are not exempt from gross income, except in cases involving wrongful death where state law mandates only punitive damages in wrongful death claims.
Employment-related lawsuits stemming from wrongful discharge or contractual breaches may lead to compensatory damages for economic loss. These damages, like lost wages, business income, and benefits, are not excluded from gross income unless a personal physical injury caused the loss.
Discrimination suits based on age, race, gender, religion, or disability can result in compensatory, contractual, and punitive awards, none of which are exempt. Dismissal pay, severance pay, or other payments for involuntary termination of employment are generally considered wages for federal employment tax purposes.
In some instances, the characterization of payments in a settlement agreement can influence their exclusion from taxable income. The IRS typically respects the parties’ intent and may consider the settlement agreement’s language to determine reporting requirements for Form 1099 in case of ambiguity regarding taxability.
