Frequent questions that arise are: Are amounts received from settlement of lawsuits and other legal remedies taxable? Are the legal fees paid in connection with these payments tax deductible? The tax code specifies that all income is taxable from whatever source derived, unless exempted by the Internal Revenue Code. The tax code does provide an exclusion from income for certain damage awards but not for others. The companion issue to damage awards is the deductibility of the legal fees associated with the damage awards and settlements. This article looks at a variety of situations and the tax ramifications.
- Physical Injury
- Wrongful Death
- Emotional Distress
- Employment Discrimination
- Sexual Harassment
- Human Trafficking Restitution
- Wrongful Incarceration
- Damages Related to Business Interests
- Legal Expenses
Physical Injury – Damages received on account of personal physical injuries or physical sickness are excludable from income whether recovery is by suit or agreement, or the amounts are received as a lump sum or in periodic payments.
When a legal action originates with a physical injury or physical sickness, then all damages (other than punitive) are treated as payments due to physical injury or physical sickness whether the recipient of the damages is the injured party.
Wrongful Death – Is considered physical injury or physical sickness for purposes of the income exclusion. In addition, where state law provides that only punitive damages can be awarded in wrongful death suits, punitive damages are excludable.
Emotional Distress – Emotional distress isn’t considered physical injury or physical sickness for purposes of the income exclusion. However, the tax code allows the exclusion of damages received for emotional distress to the extent not more than the amount paid for medical care related to emotional distress.
Employment Discrimination – No exclusion is allowed for damages received in a suit involving employment discrimination or injury to reputation, which is accompanied by a claim of emotional distress. However, the exclusion would apply to a claim of emotional distress, which was related to a physical injury or physical sickness.
Sexual Harassment Damages and Settlements – Tax reform put restrictions on business deductions related to sexual harassment damages and settlements as well as impacting the taxability of any award or settlement.
- Impact on a Business – No business deduction is allowed for any settlement, payout, or attorney fees related to sexual harassment or sexual abuse if such payments are subject to a nondisclosure agreement.
- Impact on an Award Recipient – Damages for sexual harassment and gender discrimination are not excludable and thus are fully taxable. The issue of sexual harassment qualifying as excludable physical injury or sickness has been in court on several occasions – always with the same result (it’s taxable).
Human Trafficking Restitution Payments – A defendant convicted of a human trafficking offense is required to make restitution payments to the victim. These payments are excludable from the victim’s gross income for federal income tax purposes. The payments may be to compensate the victim for costs of medical services, physical and occupational therapy or rehabilitation, transportation, temporary housing, childcare expenses, lost income, attorneys’ fees and other costs and losses the victim suffers because of the offense.
Wrongful Incarceration – Compensation received for a wrongful incarceration is not taxable. A wrongfully incarcerated individual is defined as either:
(2) an individual for whom the conviction for such offense was reversed or vacated and for whom the indictment, information, or other accusatory instrument for such offense was dismissed or who was found not guilty at a new trial after the conviction was reversed or vacated.
Damages Related to Business Interests – Generally damages related to business interests are income to the business except for damages related to injury to property. The damages are not taxable to the extent the basis of the property is reduced.
Legal Expenses – Unfortunately in most cases the legal fees end up not being deductible. The reason for that is when they are deductible, they are a tier 2 miscellaneous itemized deduction. But the current tax law has suspended all tier 2 miscellaneous deductions through 2025, so the bottom line, with some exceptions explained later, is that the legal fees are not deductible.
The insurance company paid $100,000. The legal firm got $40,000 and Melinda got $60,000. However, since the legal fees are not deductible Melinda ends up paying taxes on the entire $100,000 settlement. However, there are exceptions. Legal fees related to a taxpayer’s business or rental are deductible as a business expense. If the action was related to property, the expenses would be added to the property’s basis. An above-the-line deduction (meaning it is deductible as an adjustment to gross income, not an itemized deduction) is allowed for attorneys’ fees and costs paid by, or on behalf of, a taxpayer in connection with a claim of unlawful discrimination, certain claims against the federal government, or a private cause of action under the Medicare Secondary Payer statute. This deduction is claimed on Form 1040, Schedule 1, line 24h (2021 version).
As you can see, determining what damage awards are taxable and whether the associated legal expenses are deductible is complicated, and even if allowed, a deduction may not provide any tax benefit.