Are Wrongful Termination Lawsuit Proceeds Taxable?
- The IRS looks at the underlying claim or action to determine whether it can be excluded. Before 1996, the IRS allowed taxpayers to exclude their employment-related settlements and awards as income if they were received for back pay compensation. However, after 1996, the IRS generally requires taxpayers to include their wrongful termination lawsuit awards as ordinary income on their tax returns. Emotional distress awards are ordinary income if you received a settlement or jury award for wrongful termination based on nonphysical injuries.
- The exception to the general rule of including a wrongful termination award as income is for an award based on a physical injury. However, if you received a wrongful termination award based solely on damage to your reputation, the IRS requires that you include it as income. If you received an award for emotional distress and physical injuries, then your award may be excluded as income, and you will not have to report your wrongful termination award as income on your tax returns.
- An example of a wrongful termination award that can be excluded from income is a compensatory award for physical injuries, including chronic ulcers caused by constant worrying about your wrongful termination case. In this example, the emotional distress award can be excluded from your income because you received the award to compensate you for your physical injuries.
- If your wrongful termination suit alleged unlawful discrimination based on state or federal law, you can deduct your attorneys' fees and incidental court expenses. You may be able to deduct those fees as miscellaneous deductions if you itemize your tax deductions using Schedule A of IRS Form1040. Furthermore, you can only deduct the amount exceeding 2 percent of your adjusted gross income. As such, if your wrongful discharge and discrimination attorney's fees are less than 2 percent of your annually adjusted gross income, you can deduct the amount exceeding 2 percent.