How IRS Taxes Employment Settlements
Legal claims about employment are one of the most common kinds of legal disputes. Just about every employment suit or settlement raises tax issues for employer and employee, and there are some common misconceptions. Most plaintiffs use contingent fee lawyers, and many assume that they are only responsible for the net money they collect after legal fees. But in Banks v. Commissioner, 543 U.S. 423 (2005), the U.S. Supreme Court ruled that plaintiffs must include contingent legal fees in their gross income even if they end up with a net check. It means you have to know how to write off legal fees. Fortunately, in employment cases, careful plaintiffs should not need to actually pay taxes on the legal fees their lawyer receives.
There is a tax deduction if you know how to claim it. But you still must report the fees on your tax return as gross income, or the IRS will think you are shorting them. But if you are using an hourly lawyer and the case spans multiple tax years, you may have to pay tax on the legal fees. Miscellaneous itemized deductions (the usual deduction for legal fees) were wiped out by Congress until 2026. In some cases the legal fees can’t be deducted.
Most employment settlements involve some wages for back pay, front pay, or both. that meant withholding and an IRS Form W-2. But some amount usually represents a payment for emotional distress or other non-wage damages. The fact that the case arises out of employment does not necessarily mean that some of the settlement must represent wages, that is one of the 12 tax myths in employment suit settlements. Sometimes the parties agree that all wages have been paid. However, most of the time, treating a portion of the settlement as wages is wise for both parties, and an agreed allocation is best.
Plaintiff and defendant should arrive at a wage figure that is large enough to make the employer comfortable that it is complying with its withholding obligations. Many plaintiffs want little or no wages. Employment taxes are partially borne by the employee and partially by the employer. For the employee, the taxes at stake are 7.7% of the pay (for the entire year) up to the wage base of $147,000, and 1.45% of amount over $147,000.
Some plaintiffs favor reduced wages is to get a bigger net check at settlement time. But the plaintiff may end up worse off at tax return time the following year if they have trouble paying their taxes. Finally, getting a Form 1099 may allow for more opportunities to claim an exclusion for physical injury or physical sickness damages. It can seem like how the IRS taxes settlements is unfair.
Sometimes the wage allocation issue comes down to the plaintiff trying to position what they claim is physical sickness money. Section 104 of the tax code shields damages for personal physical injuries and physical sickness. Before 1996 “personal” injury damages were tax free, so emotional distress, defamation, and many other legal injuries also produced tax-free recoveries. That changed in 1996, and since then, an injury or sickness must be physical to give rise to tax-free money.
Unfortunately, there is still substantial confusion. Emotional distress alone is taxable, even with physical consequences such as headaches, stomachaches, and insomnia. In contrast, if there are physical injuries or physical sickness which produce emotional distress damages, those emotional distress damages can be tax-free. Many plaintiffs struggle with the chicken-or-egg issue of what comes first. Claims of post-traumatic stress disorder (PTSD) are increasing common in employment litigation, and PTSD arguably should be viewed as physical sickness, although there is no definitive tax case that says so.
Even in employment cases, some plaintiffs win on the tax front. For example, in Domeny v. Commissioner, Ms. Domeny suffered multiple sclerosis, which worsened because of workplace problems, including an embezzling employer. As her symptoms intensified, her physician determined that she was too ill to work. Her employer terminated her, causing another spike in her symptoms. Domeny settled her employment case and claimed some of the money as tax free. The IRS disagreed, but she won in Tax Court. Her health and physical condition clearly worsened because of her employer’s actions, so portions of her settlement were tax free.
If you receive a Form 1099, must you treat it as taxable? Not always. You must address the Form 1099 on your tax return, but on the right facts, you can explain that the payment was non-taxable. In the employment context, many plaintiffs argue that their employer caused them physical injuries or physical sickness. Sometimes, there as a physical or sexual assault, severe or minor in the workplace.
Sometimes the employee claims that the employer caused physical sickness or exacerbated an existing physical sickness. Sometimes the employee claims that the workplace gave them PTSD. The employer and employee may reach a compromise on the wording of the settlement agreement. But how about on the issuance of the form? The Form 1099 regulations and form instructions say that a payment of compensatory damages for physical injuries or physical sickness should not be reported on a Form 1099.
Even so, that may a bridge too far for the employer. The employer might agree that a payment is for alleged physical injuries or physical sickness, but still say they feel that they must issue a Form 1099. The issuance of the form hurts the plaintiff’s tax case—it’s always better if the plaintiff can convince the employer there should be no form. Even so, the issuance of the form does not foreclose the plaintiff’s argument that it should not be taxed.
But what if you do not receive a Form 1099? Many people seem to think that if there is no Form 1099, there can be no income, but that’s not true. Numerous kinds of payments are not required to be reported on a Form 1099. And even if the payment is clearly required to be the subject of a Form 1099, the fact that the defendant fails to issue one does not necessarily mean that you can avoid the IRS tax on settlements.
Is it worth fighting over employment case settlement agreement wording? You bet. The language of the settlement agreement does not bind the IRS or state taxing authorities. However, wording about these issues in the settlement agreement is important, in fact, you might say critical. The IRS and the Tax Court both pay attention to what the settlement agreement says, and sometimes, they seem to act as if it is the most important thing of all. The intent of the payor is a phrase that features prominently in tax cases, and there is no better statement of the payor’s intent in legal settlement than the wording of the settlement agreement. There are numerous tax cases where bad or neutral wording doomed a plaintiff’s tax claim.
Many employment disputes are emotional and difficult. Whenever possible, plan ahead for the tax issues and consider being specific about taxes so there is no dispute later. You don’t want to have a fight later about how much is subject to withholding, about exactly what tax forms are going to be issued, etc. Try to get some tax advice before signing a settlement agreement.