One of the most frequently asked questions tax professionals receive is “Are injury settlement payments are taxable?” According to Code Sec. 104(a)(2), payments received as compensation for a personal physical injury or physical sickness are not taxable. The key term here is physical. Payments for emotional distress or other reasons that do not stem from a physical injury are taxable income. Likewise, a portion of punitive damages awarded are taxable income even if they are related to the physical injury. This is ultimately because the purpose of a punitive damage award is to punish the defendant rather than to compensate from the physical injury. A recent tax memo, TC Memo 2017-129, highlighted this code when the court ruled against the taxpayer. In this particular case, the Tax Court concluded that the payments the taxpayer received during a discrimination claim settlement were taxable.
The taxpayer suffered a physical injury not related to his employment. He was unable to fully return to his job because of his disability, and asked his employer for reasonable accommodation. However, the employer refused and terminated the taxpayer. The taxpayer brought a discrimination lawsuit alleging that the employer failed to make a reasonable accommodation to allow the taxpayer to work a different, more sedentary position. Eventually, the taxpayer and employer reached a settlement and the settlement payment was included in the taxpayer’s W-2.
After receiving his settlement, the taxpayer argued with the IRS that the settlement payment should be excluded from his income because of his physical injury. The Court noted that the settlement award was not a result of the taxpayer’s physical injury, but his alleged discrimination. As with any agreement, properly wording the settlement award description is critical to help ensure the desired tax outcome. Your tax advisor should review aspects of the agreement that determine the tax treatment of the settlement, prior to the agreement being signed.
If you have questions on this matter or would like to discuss your particular tax situation, please contact Aronson’s Tax Controversy Practice Partner, Larry Rubin, at 301.222.8212 or firstname.lastname@example.org.