Are Damage Awards Taxable? Fiducial Has the Scoop!

• Find out if physical injury income is excludable.
• Get the facts about wrongful death damage awards.
• Learn about the complexities of taxing emotional distress damages.
• Discover the rules concerning damages received for employment discrimination.
• Find information about sexual harassment damages as they affect both businesses and individuals.
• Discover whether or not human trafficking restitution is excludable for victims of human trafficking.
• Learn the definition of wrongful incarceration and the excludability of damages awarded.
• Learn about the taxability of damages related to business interests.
• Legal services are a necessary part of suing for damages, but are legal expenses deductible?

Frequent questions arise about the taxability of damage awards. Are amounts received from the settlement of lawsuits and other legal remedies taxable? Are the legal fees paid in connection with these payments tax deductible? The Internal Revenue Code (IRC) specifies that all income is taxable from whatever source derived unless it is exempted.

The IRC does provide an exclusion from income for certain damage awards but not for others. The companion issue to damage awards? The deductibility of the legal fees associated with the damage awards and settlements. In this article, Fiducial examines a variety of situations and the tax ramifications.

Physical Injury

Damages received on account of personal physical injuries or physical sickness are excludable from income whether recovery is by suit or agreement, or the amounts are received as a lump sum or in periodic payments.

When a legal action is based on physical injury, the damages received are excludable, even if they are measured by reference to what would otherwise be taxable (lost wages, for example).

Wrongful Death

We consider wrongful death physical injury or physical sickness for purposes of the income exclusion. In addition, where state law provides that only punitive damages can be awarded in wrongful death suits, punitive damages are excludable.

Emotional Distress

We do not consider emotional distress as a physical injury or physical sickness for purposes of the income exclusion unless it is shown to be caused by a physical injury or sickness. However, the IRC allows the exclusion of damages received for emotional distress to the extent not more than the amount paid for medical care related to emotional distress.

Employment Discrimination

No exclusion exists for damages received in a suit involving employment discrimination or injury to reputation, which is accompanied by a claim of emotional distress. However, as stated previously, the exclusion would apply to a claim of emotional distress, which was related to a physical injury or physical sickness.

Sexual Harassment Damages and Settlements

Tax reform put restrictions on business deductions related to sexual harassment damages and settlements. This also impacted the taxability of any award or settlement.

• Impact on a Business – No business deduction is allowed for any settlement, payout, or attorney fees related to sexual harassment or sexual abuse if such payments are subject to a nondisclosure agreement.
• Impact on an Award Recipient – Damages for sexual harassment and gender discrimination are not excludable and thus are fully taxable. The issue of sexual harassment qualifying as excludable physical injury or sickness has been in court on several occasions – always with the same result (it’s taxable).

Human Trafficking Restitution Payments

A defendant convicted of a human trafficking offense must make restitution payments to the victim. These payments are excludable from the victim’s gross income for federal income tax purposes. The payments may be to compensate the victim for costs of medical services, physical and occupational therapy or rehabilitation, transportation, temporary housing, childcare expenses, lost income, attorneys’ fees, and other costs and losses the victim suffers because of the offense.

Wrongful Incarceration

The compensation received for wrongful incarceration is not taxable. We define a wrongfully incarcerated individual as either:

(1) an individual convicted of a criminal offense under Federal or state law, who served all or part of a sentence of imprisonment relating to such offense, and who was pardoned, granted clemency, or granted amnesty because of actual innocence of the offense; or

(2) an individual for whom the conviction for such offense was reversed or vacated and for whom the indictment, information, or other accusatory instruments for such offense was dismissed or who was found not guilty at a new trial after the conviction was reversed or vacated.

Damages Related to Business Interests

Generally, damages related to business interests are income to the business except for damages related to injury to property. The damages are not taxable to the extent the basis of the property is reduced.

Legal Expenses

Unfortunately in most cases the legal fees end up not being deductible. The reason for that is when they are deductible, they are a tier 2 miscellaneous itemized deduction. But the current tax law has suspended all tier 2 miscellaneous deductions through 2025, so the bottom line, with some exceptions explained later, is that the legal fees are not deductible.

Example: Melinda, became injured in an automobile accident and engaged a legal firm to handle her claim with the insurance company. The legal firm’s fee was 40% of the insurance company's settlement.

The insurance company paid $100,000. The legal firm got $40,000 and Melinda got $60,000. However, since the legal fees are not deductible, Melinda ends up paying taxes on the entire $100,000 settlement. However, there are exceptions. Legal fees related to a taxpayer’s business or rental are deductible as a business expense. If the action was related to the acquisition or retention of property, the expenses would be added to the property’s basis.

An above-the-line deduction (meaning it is deductible as an adjustment to gross income, not an itemized deduction) is allowed for attorneys' fees and costs paid by, or on behalf of, a taxpayer in connection with a claim of unlawful discrimination, certain claims against the federal government, or a private cause of action under the Medicare Secondary Payer statute. You can claim this deduction on Form 1040, Schedule 1, line 24h (2021 version).

The Complications Involved in Taxing Damage Awards

As you can see, determining what damage awards are taxable and whether the associated legal expenses are deductible is complicated. Even if allowed, a deduction may not provide any tax benefit. As every circumstance is unique, you should call your Fiducial representative to determine what the tax ramifications might be in your situation.

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