Every April, our collective stress level rises as we scramble to meet our tax deadlines. Particularly tricky federal tax issues come up when an employee either receives money from a lawsuit settlement with his or her employer, or severance pay upon leaving a job. In most situations both are taxable as income, but subtleties in the law create some exceptions.

A settlement is an agreement reached between parties to a lawsuit. Usually the plaintiff receives money damages to compensate for his or her injury, and in exchange agrees to dismiss the legal claims against the defendant.

Very broadly, most settlements are taxable under federal law, which takes a very inclusive approach to what constitutes taxable income. Except for a few exceptions, "gross income means all income from whatever source derived." So the basic rule is that if you earn money, you must pay taxes on it. Courts have looked at whether the receiver of money has more wealth that they control.

Federal law specifically excludes from taxable income damage awards and settlements for "personal physical injuries or physical sickness" – except for punitive damages, which are taxable. Punitive damages are more in the nature of fines and are meant to punish wrongdoers for particularly reprehensible behavior, above and beyond money to compensate for the cost of the losses themselves.

The relationship between employee and employer is often significant both personally and economically, leaving the door wide open to the possibility of major conflict. Employers by definition yield more power and control in the employment relationship, and accidental or deliberate harm to employees can occur in the workplace.

Lawsuits filed by employees against employers for a variety of reasons are common:

• For unlawful discrimination such as in promotion, firing and pay on the basis of attributes like race, national origin, gender, age, disability, religion, veteran status and others
• For breaches of employment contracts, including over benefits
• For wrongful termination
• For retaliation
• For sexual harassment
• For torts like defamation, fraud, invasion of privacy, intentional infliction of emotional distress, concealment of or failure to warn of hazards, negligence and more

Usually recovery of damages for physical (and sometimes mental, depending upon the state) injuries in the workplace is exclusively governed by workers’ compensation, and workers’ compensation awards are generally not taxable. The exclusive nature of workers’ compensation means that usually it is the only legal remedy available to an injured worker against his or her employer.

In many states, however, lawsuits are allowed directly against employers outside of the workers’ compensation scheme for egregious conduct like intentional or malicious harm.

Application of the rule that damages for physical harm are not taxable, along with interpretation by the Internal Revenue Service (IRS) and the courts, have had the following consequences for amounts received in settlement of most employment claims:

• Nontaxable: damages for physical injury or sickness; damages to compensate for pain, suffering and emotional distress only if caused by physical injury; medical expenses (even for mental treatment); most attorneys fees (deduction allowed); interest, even on money otherwise taxable in the award
• Taxable: lost wages; back pay; front pay (finite amount of future lost wages); damages for pain, suffering and emotional distress not from physical injury (except related medical expenses) even where such mental distress causes physical symptoms of stress like headaches, chest pain and stomach upset; punitive damages (even as punishment for causing physical injury); liquidated damages (preset compensation for violation of certain employment laws)

Many view as harsh the outcome that some suffering from mental harm are getting tax-free compensation just because that mental harm stems from a physical injury, versus those suffering mental harm whose compensation is taxed only because it is independent of an earlier, related physical injury or sickness.

Because of the importance of physical injury in federal taxation of employment settlements, employees should carefully document medical proof of such injuries. Plaintiff’s lawyers should be sure to clearly refer to physical harm in all related communication and court pleadings.

When crafting or agreeing to language in the settlement agreement, rather than agreeing to a vague lump sum that could ultimately be classified as falling within the taxable categories enumerated above, the damages should be individually classified according to the taxable or nontaxable categories they represent. The IRS generally will tax the entire lump-sum award unless it is clearly divided into damage categories, some of which may not be taxable.

Taxation consequences generally should be part of the plaintiff’s consideration in considering acceptable settlement terms. For example, if a large settlement falls all or mostly into taxable categories, especially if the amount reaches a level high enough to fall under the alternative minimum tax, the tax liability may justify holding out for a higher award.

In some states that allow recovery of workers’ compensation damages for mental or emotional harm, a workers’ compensation award may be a way to recover for mental harm in a way that is not taxable to the employee.

Severance pay, sometimes also called separation or termination pay, is a payment of money by an employer to an employee when the employee is terminated, often because of downsizing or reorganization on the part of the employer. Sometimes an employee may have a choice between job relocation and a severance package.

Severance pay is meant to assist an employee during the transitional time between jobs, which is often an unplanned-for surprise. Severance payments may be made according to an employer’s internal policy or plan, required by state law, or pursuant to a one-time arrangement.

The basic rule is that simple severance will be taxable as income, subject to withholding when paid out. Salary continuation when a job is lost is taxable. However, complicated tax questions can arise when severance money comes from certain types of employment trusts, or qualified retirement or benefit plans.

This article is a simplified summary of some complicated issues. Many complex matters in this area are being litigated in the courts, and the courts are often split on the answers to particular questions. It would be difficult for an employee to bring a lawsuit against his or her employer without the guidance of an experienced employment law attorney with knowledge of applicable tax laws. Negotiation against a former employer would be challenging without the support of legal counsel and failure to properly classify damages could result in a high tax burden. In addition, issues of state tax law may arise that a lawyer licensed in the particular state would be qualified to examine.