The IRS does not require taxpayers to pay income taxes on their compensatory awards if they received them as compensation for physical injuries or illnesses. If a court or jury awarded the taxpayer for physical losses by ordering the opposite party to pay compensatory damages, then under the Internal Revenue Code Section 104(a) (2), the award is not taxable. To determine whether a taxpayer is liable for income taxes on a compensatory award, the IRS reviews the underlying lawsuit. As such, if a taxpayer sues his employer for work-related injuries and prevails, the subsequent award is not taxable.
Compensation for Emotional Distress
Taxpayers must pay income taxes on compensatory awards that are solely awarded for emotional distress. If the award does not address a physical harm or illness, the winning party must pay income taxes on the award. For instance, defamation of character claims are taxable, since the defamation claims arise from nonphysical injuries. Additionally, torturous interference claims based on contractual rights are taxable. However, the IRS allows taxpayers to receive tax-free treatment on the part of their awards that were based on physical injuries. Taxpayers who win lawsuits and receive compensation for employment-based claims must generally pay income taxes on their awards.
Compensation for Physical Injuries
Settlement awards covering physical injuries are not taxable if a taxpayer's award was based on an underlying injury. For instance, if a taxpayer sues her employer based on sexual discrimination, and she suffers migraine headaches as a result of her employer's misconduct, she can exclude her award compensating her for resulting physical injuries. However, if her sexual discrimination complaint was not based on a physical injury, she must include her compensatory damage award.
Types of Lawsuits
The Internal Revenue Service requires taxpayers to pay income taxes on emotional claims charging employers with wrongful discrimination. Additionally, taxpayers who win compensatory damage awards based on defamation or libel must pay income taxes on their awards if their claims are solely based on emotional damages. Wrongful death claims, on the other hand, are generally exempt from income taxes. Thus, compensation awards based on wrongful death are not taxable, and surviving family members receive those awards on a tax-free basis.
Since tax laws can frequently change, do not use this information as a substitute for legal advice. Seek advice through an attorney licensed to practice law in your state.