The IRS can tax the majority, or even all, of a settlement or award from an employment lawsuit. For example, under current law, an employee who settles a discrimination case for $50,000, with a court-awarded $75,000 attorney fee now receives as little as 13.2 percent of the total award, or $16,707. This may change if Congress passes the Civil Rights Tax Relief Act, which is supported by the American Bar Association, the U.S. Chamber of Commerce, and dozens of business, legal, labor and public interest organizations. If the Act passes, under the same scenario, the same employee would receive $44,624, a difference of almost $28,000. Moreover, for this person to receive the latter amount under current law, the case would have to be settled for $107,000.
In 1996, the government began to tax awards and settlements where employees received damages for emotional distress. This affected many settlements or awards issued in discrimination suits. In contrast, physical damages resulting from negligence (e.g. slip-and-fall cases) are tax free, while damages for psychological injury caused by intentional discrimination are taxable. This change resulted in employees seeking higher damage awards to offset the negative tax consequences, further causing either increased litigation or larger settlements. The proposed Act eliminates the taxation of emotional distress awards in discrimination cases.
Back pay awards are considered taxable income, and IRS regulations require that they be taxed in the year received, though the award may cover many years worth of wages. As a result, employees who recover for several years of back pay face a higher income tax rate. The Act would allow employees recovering back wage awards to be taxed over the number of years for which the award was designed to compensate, thus lowering the tax rate.
People who bring civil rights cases can also be taxed on the portion of the award paid as attorneys’ fees. The same award is taxed twice, since attorneys are taxed on it as well. Individuals bringing civil rights cases are commonly taxed on their entire award, even the portion paid to their attorneys. Most appellate courts have ruled that attorney fees must be included as part of the successful plaintiff’s income, and the U.S. Supreme Court has repeatedly declined to address this issue. Applying this law, the combined attorney fees and tax on an award or settlement may consume the majority or all of the damages in the award. The Act would eliminate the taxation of attorneys’ fee awards completely.
** This information is provided by the attorneys at Passman & Kaplan, P.C., a law firm dedicated to the representation of federal employees worldwide. For more information on Passman & Kaplan, P.C., go to http://www.passmanandkaplan.com. **