You generally must pay federal tax on all income you receive but there are some exceptions when you can exclude it. For example, compensatory awards and judgments for “personal physical injuries or physical sickness” are free from federal income tax under the tax code. This includes amounts received in a lawsuit or a settlement and in a lump sum or in installments.
But as taxpayers in two U.S. Tax Court cases learned, not all awards are tax-free.
For example, punitive damages and awards for unlawful discrimination or harassment are taxable. And the tax code states that “emotional distress shall not be treated as a physical injury or physical sickness.” Here are the facts of the two cases.
Case #1: The payment was intended to compensate for personal harm, rather than physical injuries
After receiving a settlement of over $327,000 from a lawsuit against her former employer, a taxpayer and her spouse neglected to report any portion of the payment on their joint tax return for the year in question. As a result, the IRS found that the couple owed over $119,000 in taxes and penalties.
Although the settlement agreement provided the payment was “for alleged personal injuries,” the Tax Court stated there was no evidence that it was paid on account of physical injuries or sickness. The court noted that the taxpayer’s complaint against the employer “alleged only violations of (state) labor and antidiscrimination laws, wrongful termination, breach of contract, and intentional infliction of emotional distress.”
The taxpayer argued that he had a physical illness that caused his employer to terminate him. But he didn’t provide a “direct causal link” between the illness and the settlement payment. Therefore, the court ruled, the amount couldn’t be excluded from his gross income. (TC Memo 2022-90)
Case #2: Legal malpractice settlements or payments are not eligible for tax exclusion.
A taxpayer was injured while being treated at a hospital, leading her to sue for negligence. When her case was dismissed, she brought a legal malpractice claim against her attorneys, ultimately settling for $125,000. The taxpayer did not report this settlement on her tax return, prompting an IRS audit that resulted in a bill for over $32,000 in taxes and penalties.
The taxpayer argued that the payment was received “on account of personal physical injuries or physical sickness” because if it wasn’t for her former attorneys’ allegedly negligent representation, she “would have received damages from the hospital.” The IRS argued the amount was taxable because it was for legal malpractice and not for physical injuries. The U.S. Tax Court and the 9th Circuit Court of Appeals agreed with the IRS. (Blum, 3/23/22)
Strict requirements and Planning Before Agreement Signed
As you can see, the requirements for tax-free income from a settlement are strict. The best time to modify the agreement so that more of the settlement is treated as tax-free is BEFORE it is agreed to and signed by both parties. If you are in the process of being awarded a court or out-of-court settlement, consult with your tax advisor about structuring alternatives that support tax favorable tax reporting treatment to the recipient.