Understanding Taxes on Your Employment Settlement: What Every Employee Should Know

If you’ve just reached a settlement in your employment case, congratulations — that’s a major milestone. But before you start planning how to spend your settlement money, there’s one crucial question to consider: How much of your settlement will you actually keep after taxes?

Many employees are surprised to learn that most employment settlements are taxable. Understanding the tax implications upfront can help you make informed decisions and avoid unwelcome surprises at tax time.

Most Employment Settlements Are Taxable

In most cases, your employment settlement will be treated as taxable income. This includes payments for:

• Back pay (wages you should have received)

• Front pay (future lost wages)

• Emotional distress damages

• Punitive damages

• Liquidated damages

• Interest on any of the above

There is one important exception: payments you receive “on account of personal physical injuries or physical sickness” may be tax-free. This only applies if the injury involves observable physical harm, such as:

• Bruising or cuts

• Swelling or bleeding

• Other documented bodily injuries

  
  

However, there is an important caveat: Physical symptoms caused solely by emotional distress — like headaches, insomnia, or anxiety — do not qualify for this exemption. Any compensation for emotional or psychological effects (e.g., anxiety, PTSD) is taxable. Only observable and documented physical injuries qualify for tax-free treatment. Examples of physical injuries that do qualify as tax-free are:

1. Workplace Accidents or Injuries

   • Example: Slipping on a wet floor causing bruises or cuts, or chemical exposure/burns in a lab or workplace.

2. Repetitive Strain or Accommodation-Related Injuries 

   • Example: Carpal tunnel or wrist injuries from repetitive work, or injuries caused by an employer’s failure to accommodate (e.g., not allowing light duty), documented by a doctor.

3. Physical Injury from Workplace Assault or Sexual Harassment

   • Example: Bruises, cuts, or other documented bodily harm resulting from an assault at work.

     
     

Structuring Your Settlement: W-2 vs. 1099 Income

How your settlement is structured can significantly affect your taxes. Employers often agree to divide the payment between W-2 wages and Form 1099 income (non-wage damages). A 50/50 split between W-2 and 1099 income is common. Employers may allow a higher 1099 portion, but usually no more than 80%, because they are cautious about IRS scrutiny and potential audits.

What to Consider in Structuring:

1. W-2 Income

   • Is treated like regular wages.

   • Subject to income tax withholding, Social Security (FICA), and Medicare taxes.

   • Taxes are withheld upfront, but take-home pay is lower.

   • Purpose: Usually covers back pay or front pay.

2. 1099 Income

   • Paid without taxes withheld.

   • You are responsible for paying income tax and self-employment tax.

   • Estimated tax payments may be required.

   • Purpose: Typically covers non-wage damages such as emotional distress, punitive damages, or interest.

3. Balance Cash Flow and Tax Risk

   • A larger 1099 portion means more cash upfront but more tax responsibility later.

   • A larger W-2 portion reduces immediate cash but simplifies tax reporting.

Attorney’s Fees and Taxes

Many clients are surprised: both you and your attorney may be taxed on the attorney’s fees. The IRS treats attorney fees as part of your taxable income, even if the check goes directly to your lawyer. Your attorney also reports and pays taxes on the fees they receive. Fortunately, in many employment cases, you can take an “above-the-line” deduction for attorney fees, reducing your adjusted gross income (AGI) and overall tax burden.

Protect Yourself: Key Takeaways

1. Plan for taxes early — don’t spend settlement funds before understanding tax implications.

2. Consider the W-2/1099 split — employers usually cap the 1099 portion at 80% to avoid IRS scrutiny.

3. Document physical injuries — if claiming a tax-free allocation, maintain medical records and clearly allocate in the settlement.

4. Understand attorney fee taxation — you’ll be taxed even if the fee goes directly to your lawyer.

5. Work with professionals — your attorney and CPA can help structure the settlement to minimize surprises.

The Bottom Line

Taxes shouldn’t dictate your settlement decisions, but understanding them is essential for financial planning. The IRS places the burden on you to prove any portion of your settlement is tax-free, so documentation and professional guidance are critical.

Every settlement is unique. Work with your employment attorney and a qualified tax professional to ensure your settlement is structured properly and that you’re prepared for any tax obligations.

For more information on structuring settlement agreements to appropriately address taxation, the IRS provides guidance on determining the correct treatment of employment-related settlement payments (IRS PMTA 2009-035).

Legal Disclaimer: This article is intended for informational purposes only and should not be construed as legal advice. For personalized guidance on your specific situation, please consult with a qualified employment attorney.

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Deborah Yim is the founder and managing attorney of the Primera Law Group. She focuses her practice exclusively on representing employees and small businesses in all facets of labor and employment law. With over 22 years of legal practice, Deborah has also served as an Assistant U.S. Attorney at the U.S. Department of Justice, a corporate litigator at a national law firm, and an employment attorney representing the U.S. Department of the Interior. Read more about Deborah here.