When it comes to figuring out if awards and settlements are taxable, we can split them into two main groups: physical injuries and non-physical injuries. Within these groups, there are usually three types of claims: actual damages, emotional distress damages, and punitive damages.

Before August 21, 1996, the tax code didn’t mention “physical” in relation to personal injuries or sickness. But then it was updated to exclude from gross income any damages received for personal physical injuries or sickness, except for punitive damages. So, if you get compensatory damages, including lost wages, for a physical injury, they’re not taxable.

On the other hand, damages for non-physical injuries like emotional distress, defamation, and humiliation are generally taxable but aren’t subject to Federal employment taxes. Emotional distress recovery must be linked to physical injuries or sickness unless it’s for actual medical expenses related to emotional distress that wasn’t previously deducted.

After the 1996 amendment, mental and emotional distress from non-physical injuries are only excludable from gross income if they’re due to physical injury or sickness. Punitive damages aren’t excludable, except in wrongful death cases where state law only provides for punitive damages.

Employment-related lawsuits, like wrongful discharge or contract breaches, can result in damages for economic loss, which aren’t excludable from gross income unless caused by a physical injury. Discrimination suits can generate various awards, none of which are excludable under the tax code.

Generally, dismissal pay, severance pay, or other payments for involuntary termination are considered wages for federal employment tax purposes. Payments made on behalf of a claimant are subject to information reporting requirements, so defendants or insurance companies issuing settlement payments must issue a Form 1099 unless the settlement qualifies for a tax exception.

Sometimes, a tax provision in the settlement agreement can result in payments being excluded from taxable income. The IRS usually respects the intent of the parties. If the agreement is silent on taxability, the IRS will look at the payor’s intent to determine reporting requirements.

When it comes to payments to attorneys, the tax code states that when a payor makes a payment to an attorney for an award of attorney’s fees in a settlement, the payor must report the attorney’s fees on separate information returns with both the attorney and the plaintiff as payees. So, Forms 1099-MISC and W-2 must be filed and furnished to both the plaintiff and the attorney when attorney’s fees are paid as part of a settlement agreement.