In employment cases, damages are usually taxable, and usually at least partially as wages, as nearly every employment case has a wage component. Employer and employee usually agree on a wage figure, and the balance goes on a Form 1099.

Sometimes, there can be a tax-free portion too. All compensatory damages flowing from a physical injury or physical sickness are excludable from income. Exactly what is “physical” isn’t clear, and some of it seems like semantics. If you claim the defendant caused you to become physically sick, that sounds tax free. But it if emotional distress causes you to be physically sick, that sounds taxable. 

The order of events and how you describe them matters to the IRS. It can seem artificial, and wording is important. Some of the line-drawing comes from a footnote in the legislative history that added the ‘physical’ requirement. It says “emotional distress” includes physical symptoms, such as insomnia, headaches, and stomach disorders, which may result from such emotional distress.  

Medical records and settlement agreement language can help. With the right combination, you may be able to resolve an IRS query or audit. To exclude a payment from income on account of physical sickness, keep evidence that the plaintiff made the claim. Keep evidence that the defendant was aware of the claim and considered it in making payment. To prove physical sickness, keep evidence of medical care and of the claim that the defendant caused or exacerbated the condition. The more medical evidence the better. Prepare what you can at the time of settlement and tax return preparation.

Here are two examples:

Domeny v. Commissioner

Ms. Domeny suffered from multiple sclerosis. Her MS got worse because of workplace problems, including an embezzling employer. As her symptoms worsened, her physician determined that she was too ill to work. Her employer terminated her, causing another spike in her MS symptoms. She settled her employment case and claimed some of the money as tax free. The IRS disagreed, but Ms. Domeny won in Tax Court. Her health and physical condition clearly worsened because of her employer’s actions, so portions of her settlement were tax free.

Parkinson v. Commissioner

Mr. Parkinson suffered a heart attack while at work. He reduced his hours, took medical leave, and never returned. He sued in state court alleging that the employer’s misconduct caused him to suffer a disabling heart attack at work, rendering him unable to work. He settled his employment case and claimed some of the money as tax free. The IRS disagreed. The Tax Court said damages received on account of emotional distress attributable to physical injury or physical sickness are tax free. The Tax Court said the IRS was wrong to argue that one can never have physical injury or physical sickness in a claim for emotional distress.

Conclusion

Whenever possible, settlement agreements should be specific about taxes. As you might expect, tax language in a settlement agreement does not bind the IRS. Even so, you might be surprised at how often the IRS pays attention in an audit if you can hand them a settlement agreement that says something explicit about taxes. It can sometimes be enough to make them walk away. Try to be explicit in the settlement agreement about tax forms too.