When you receive a court award or settlement payment the amount you receive may be taxable depending on the reason for the award or settlement. According to the IRS, compensatory damages you receive for personal physical injury or personal sickness are not taxable, whether you receive them in a lump sum or in installments. To determine whether other types of awards or settlements are taxable, you have to consider the underlying basis.
In most cases, punitive damages are considered taxable income. If you receive punitive damages in addition to compensatory damages for physical injury or sickness, the portion of the award or settlement that represents punitive damages would be taxable.
Compensation for emotional distress would be taxable unless it relates to damages for physical injury or sickness. For example, compensation for emotional distress due to discrimination, fraud, or harm to your reputation would be taxable. But if you receive damages for out-of-pocket expenses for medical care for emotional distress, including for symptoms such as headaches, insomnia, and stomach disorders, that part of the damages would not be taxable. If you itemize deductions you would generally be able to claim the medical expenses you paid as an itemized deduction to the extent your total medical expenses exceed 7.5% of your adjusted gross income.
If you receive an award or settlement for back pay in a claim related to employment, you would include the amount you receive as wages, salaries and other employee compensation. This includes payments you receive for unpaid health and life insurance premiums. Your employer should include this amount in your W-2. But compensation for lost wages that is included in an award or settlement for compensatory damages for a physical injury or sickness would be excludible from taxable income.
You can claim a deduction for attorney fees and court costs for an unlawful discrimination claim, to the extent you are reimbursed for those costs as part of the award or settlement payment you receive. This deduction is claimed as an adjustment to gross income, so you can claim it even if you don’t itemize deductions. The deduction is claimed as a write-in adjustment on line 36 of Form 1040, noting “UDC” alongside the amount.
Damages for patent or copyright infringements, breach of contract, business interference, or lost profits are generally taxable. The damages would be reported as income according to how the lost income or profits would have been recorded, for example as business income or royalties. Amounts you receive in settlement of pension rights are generally taxable. This award or settlement would be reported according to how you would report your pension income. And interest you receive on any award or settlement would be taxable as interest income.
As pointed out by the IRS, “compensatory” is often interpreted as nontaxable. But compensatory only means compensation for a loss. While compensatory damages for a physical injury or sickness are not taxable, other types of compensatory damages, such as for property damage or loss of profits, may be taxable. And, awards or settlements may include different types of compensatory damages, including punitive damages. So it is important to analyze the award or settlement and allocate the respective amounts received in order to determine their taxability.
