As we noted in Part One last week, all money you receive from any source is subject to federal income tax unless a specific exclusion applies. IRC § 104 of the U.S. Internal Revenue Code (IRC) covers exclusions from taxable income with respect to lawsuits, settlement amounts, and awards.

To give you a further sense of how complicated this seemingly straightforward tax issue can get, here are some of the rules governing taxable income under IRC § 104 and other provisions:

• Punitive damages are almost always included in income and are taxable. The only exception being in certain wrongful death cases.
• Compensatory damages on account of a personal physical injury or physical sickness are excluded from income and not taxable.
• Compensatory damages for a personal non-physical injury or non-physical sickness that is on account of a physical injury or sickness are excluded from income and not taxable.
• Compensatory damages for any other non-physical injury or non-physical sickness, including emotional distress, are included in income and taxable.
• Payments for medical compensation claims to treat non-physical injuries or non-physical sicknesses are excluded and not taxable.
• Compensation for lost back pay is a wage that is subject to federal income tax, and compensation for lost front (future) pay wages may also be subject to employment tax.
• As a general rule, dismissal pay, severance pay, or other payments for involuntary termination of employment are wages for federal employment tax purposes.
• If you are self-employed, compensation for amounts arising from income-producing activity related to your trade or business is subject to self-employment taxes.
• Amounts compensating for attorney fees are generally included in income and taxable, although you may be allowed a tax deduction in the same amount. These rules are particularly tricky.

As we said in the last post, it’s best to specify your own allocation of award money in your Settlement Agreement and justify that allocation through the best documentation possible. But keep in mind that the IRS is not required to respect your allocation, and may investigate it closely if you get audited. They will look at all of the facts and circumstances surrounding the case, as well as interview those involved and review documentation, and then make their own determination of how the award should be allocated. For example, if the underlying claim in the lawsuit included a request for lost wages, then the IRS may look closely at whether part of the settlement award should have been allocated to taxable lost wages. If they disagree with your assessment as stated on your income tax return, then you could be subject to penalties for failure to properly report taxable income.

In Part Three of this post, to be published next week, we’ll look at one of the most controversial issues in this area — how the IRS differentiates between physical and non-physical injuries and sicknesses for tax purposes.