Whether any damages award or settlement you receive is taxable depends on the nature of your case and why you received payment.
Taxes on Personal Injury Awards
Generally, any damages or settlement awarded to compensate you for medical expenses, lost wages, and pain, suffering, and emotional distress are not taxed as income. This is true whether you’re receive a lump sum payment or in installments.
Punitive damages, even from a personal injury lawsuit, are usually taxable. Punitive damages aren’t to compensate you for your losses, they are to punish the wrongdoer and to discourage others from acting as the wrongdoer acted. In some states, punitive damages awarded in a wrongful death case are not taxable, so you should check with your tax adviser for more information.
Taxes on Non-Personal Injury Awards
Damages awarded in a claim not involving personal injury—such as, a discrimination suit or a suit to collect back pay— are generally taxable as ordinary income at your personal income tax rate. Check with your tax adviser for more information.
The following are generally taxed as ordinary income, but you should check with your tax adviser for more information:
- interest on any award
- most payments for lost wages or lost profits
- most punitive damages (regardless if physical injury or illness is involved)
- amounts received in settlement of pension rights (if you didn’t pay into the plan)
- damages for patent or copyright infringement, breach of contract, or interference with business operations
- back pay and damages for emotional distress for claims in Title VII cases (these are discrimination claims against employers).
Taxes on Attorney Fees
Often, attorneys represent plaintiffs on a contingency basis, meaning they get a percentage of any damages or settlement that they obtain for their client. In such cases, the client must pay tax on the entire award received, including the amount paid to the attorney if the award is taxable. Similarly, if the losing side is ordered to pay attorney fees and costs, the amount is generally considered taxable income.
As a rule, whenever your damages are taxable you are allowed to deduct your attorney fees. This can be a business deduction if the lawsuit was related to your business. If not, it would probably be a personal itemized deduction. In certain discrimination cases, you can deduct attorney fees directly from your gross income. As always, you should check with your tax adviser for more information.
Taxes on Damages Awarded for Emotional Distress
Tax treatment compensation for emotional distress depends on the case. Emotional distress isn’t a physical injury or sickness. However, generally speaking, damages for emotional distress caused by physical injury or sickness are not taxable.
On the other hand, damages for emotional distress that didn’t arise from physical injury or sickness are usually taxable income. For example, damages for emotional distress arising from an employment discrimination claim are taxable.
There is, however, a limited exception when emotional distress leads you to seek medical treatment for physical symptoms, such as headaches, insomnia, and stomach disorders. In this event, emotional distress damages up to the amount of your actual medical care expenses may be tax free.