Taxation of Litigation Awards and Deductibility of Attorneys’ Fees

We are frequently asked about the tax consequences of receiving a judgment or settlement in a lawsuit.  Damages received as the result of a breach of contract or property damage have always been, and continue to be, taxable.  For personal injury actions, however, the tax consequences have changed quite a bit over the last 20 years.

Prior to 1996, if someone received an award for personal injuries, other than punitive damages, all amounts received were not taxable and/or were excluded from the injured party’s income.  As a result, individuals receiving an award for discrimination argued to exclude the award from taxable income as an “injury to their person.”

But in 1996, Congress changed the law so only awards and/or settlements resulting from a physical injury (such as a severed arm) were excluded from taxable income.  Hence, the key to excluding the award from taxable income was alleging and/or proving some sort of physical injury (i.e. a concussion, broken limb, or even a slight bruise).  Importantly, if the award resulted from a physical injury, the entire amount is excludable from income, regardless of how the monetary amount is characterized (i.e. medical expenses, pain and suffering, lost income/wages). 

The law change had the biggest effect on employment and/or other discrimination claims where there was no physical injury to the plaintiff.  In these cases, awards and/or settlements are taxable, but how the total award is allocated between different types of damages becomes an issue.  For instance, any “lost wages” awarded are subject to federal income tax and Social Security and Medicare withholdings; while the portion allocated to pain and suffering is not.  Amounts allocated to reimbursement of out-of-pocket medical expenses can be excluded from taxable income, but only if the original expense was not previously deducted.

A subtle issue arises with respect to damages awarded for emotional distress.  If a physical injury leads to or causes emotional distress, the amount of the award allocated to emotional distress is excludable under the above rule (indeed, the entire award is excludable).  In contrast, if the emotional distress leads to or causes physical injury, the award will be taxable.  For example, if an employee is harassed but not physically touched, and this led to his/her getting physically ill with insomnia, headaches, and stomach disorders, any damages received from those ailments are taxable.

A corollary issue is whether attorneys’ fees and costs incurred to obtain the award can be deducted.  Generally, costs incurred to produce taxable income are deductible.  So, to the extent the award relates to a physical injury (excludable from tax), the costs cannot be deducted under any circumstances.  Where the award is taxable, however, the 2017 Tax Act eliminated most Miscellaneous Itemized Deductions until 2025.  As a result, a person who receives a taxable award or settlement will be taxed on the gross award, without the ability to deduct any of the costs or fees incurred to obtain it.  There are, however, special rules related to federal discrimination claims that may afford better treatment.

If you have questions about a claim you have or may have, contact the attorneys at Anderson & Jahde, P.C.

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