Tax Consequences of Employment Discrimination Settlements
| Jurisdiction | United States,Federal |
| Citation | Vol. 12 No. 11 Pg. 1802 |
| Pages | 1802 |
| Publication year | 1983 |
1983, November, Pg. 1802. Tax Consequences of Employment Discrimination Settlements
One significant responsibility of practitioners involved in the settlement of claims of employment discrimination is to advise their clients regarding the tax consequences of the settlement. The issue should play a significant role in the considerations of both management and the discrimination claimant in determining their respective positions relative to settlement negotiations. From management's perspective, failure properly to account for and deduct appropriate payroll taxes from the settlement can result in additional liability to the Internal Revenue Service ("IRS") and state tax authorities.(fn1) Similarly, practitioners advising the employment discrimination claimant will wish to avoid having to contend with the dissatisfaction of a client who receives a net amount substantially less than he believed would be realized from the settlement or, even worse, a client who is subsequently determined to be liable to the IRS for unpaid taxes on the proceeds of the settlement.(fn2)
This article provides an overview of the more significant decisions of the IRS and the courts dealing with the factors to be evaluated in determining the tax consequences of employment discrimination settlements. However, the article is by no means an exhaustive analysis of all of the tax issues which can arise out of such settlements.
As a general rule, amounts received by an employee in settlement of an employment discrimination claim or lawsuit are taxable as ordinary income.(fn3) Without question, payments received in settlement of a claim for back pay based upon alleged employment discrimination constitute taxable income for the claimant(fn4) and require the withholding of income and social security taxes and payment of the employer's contributions for social security and federal unemployment taxes by the employer.(fn5)
If the employee's claims against the employer include claims for personal injuries, under certain circumstances, a portion of the settlement amount may be excludable from income and, accordingly, non-taxable. Section 104(a)-(2) of the Internal Revenue Code of 1954, as amended, excludes from gross income "the amount of any damages received (whether by suit or agreement) on account of personal injuries or sickness."(fn6) The term "damages" is defined as "an amount received (other than workmen's compensation) through prosecution of a legal suit or action based upon tort or tort-type rights, or through a settlement agreement entered into in lieu of such prosecution."(fn7) Non-physical personal injuries include claims for emotional distress, mental anguish, humiliation, and pain and suffering.
Even if the settlement includes the resolution of claims for personal injury, the IRS does not automatically treat a portion of the settlement as non-taxable income under § 104(a)(2). If the settlement agreement fails to allocate the portion of the gross settlement amount that is for settlement of the claim for back pay and the portion that is for settlement of the claim for personal injury, the IRS will normally treat the entire settlement amount as back pay and thus taxable as wages.(fn8)
One of the leading cases to address this issue was the decision of the Tax Court in Hodge v. Commissioner.(fn9) In Hodge, the claimant received $23,563.66 in settlement of his discrimination claims brought under Title VII of the Civil Rights Act of 1964.(fn10) The claimant's attorney had threatened to amend the complaint to also assert claims for personal injuries, but the parties settled the case before an amended complaint was filed. On his income tax return for the year in which the settlement was received, the claimant excluded half of the...
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