Taxation of Severance Pay and Employment Law Settlements

By Chris Royer



This article answers frequently asked questions about the U.S. taxation of income received as severance pay or the settlement of an employment law claim. It is general information for employees and employment lawyers and not legal advice. Tax laws change. This article was written or updated in 2007. Consult with a tax attorney or a qualified tax professional to ensure your compliance with U.S. internal revenue laws when you receive severance or settlement proceeds.

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If I settle my employment discrimination case, do I have to pay taxes?

As a general proposition, yes.  More specifically, it depends on how you allocate the settlement among the various types of damages.  The following table shows the different types of damages and whether they are taxable as income to the client:


Type of Damage

Taxable to the Client as Income?

Who Says?[1]

Lost wages/back pay

and front pay




26 U.S.C. § 104(a)(2); Commissioner v. Schleier, 515 U.S. 323 (1995).


Compensatory damages for emotional distress, pain and suffering

(NOT associated with personal physical injury and NOT including medical expenses from emotional distress)








26 U.S.C. § 104(a)(2)

Compensatory damages for emotional distress, pain, and suffering

(associated with personal physical injury)






26 U.S.C. § 104(a)(2)

Medical expenses associated with emotional distress




26 U.S.C. § 104(a)(2)

Punitive damages





26 U.S.C. § 104(a)(2)

Damages arising from a personal physical injury or sickness



26 U.S.C. § 104(a)(2)

Liquidated damages (such as FLSA, FMLA, ADEA)




Commissioner v. Schleier, 515 U.S. 323 (1995) (where liquidated damages are punitive in nature, they are taxable under 26 U.S.C. § 104(a)(2)).


Attorneys’ fees and costs of suit associated with employment discrimination claims


26 U.S.C. § 62(a)(20); (e)  

(this is the first CRTRA)

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If (almost) everything is taxable, can I at least reduce the amount of tax?

Some severance pay or employment law settlements are taxed more than others. Wages or a settlement of a wage claim are taxed more than compensation for emotional distress.Hence, properly treating amounts received as compensation for emotional distress will reduce the employee's tax burden.

The employer typically has the first say in how to treat money paid as severance or settlement and will process money received as compensation for unpaid wages through payroll. However, where the employee's circumstances permit, the employer and employee can agree, typically as part of the settlement, to allocate settlement proceeds tothe available forms of income, or the employer can leave it up to the employee (not a recommended practice for employers).

The employee reports the amounts received on his or her tax form.  The employee will allocate the settlement proceeds to the various types of income at this time.           f, for some reason, the IRS conducts an audit and tries to challenge the way the client has treated the settlement for tax purposes.  If there is no allocation in the agreement, then the IRS is more likely to try to treat all of the settlement as taxable.

When a settlement expressly allocates the settlement proceeds among various types of damages, the allocation is generally binding for tax purposes, as long as the agreement is entered into by the parties in an adversarial context; at arm’s length; and in good faith. [2]

An express allocation will be disregarded only where the facts and circumstances surrounding the payment indicate that the payment was intended to be for a different purpose. If the settlement agreement contains an express allocation of the settlement proceeds, and the allocation is colorable in light of the claims in the Complaint, then it is more likely to be approved in an audit.

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What are options for allocating severance pay or settlement proceeds?

If the money you received is a lump sum amount or salary continuation paid as severance at the time you lose your job, your may have just one option, which is to treat it as wages. In that event, you will see the normal withholdings and your employer will send you a W-2 for that year.
If you receive a lump sum amount as a settlement of an employment law claim, then you must decide how to allocate the amounts, and which forms to use. You have two choices, Form W-2 and Form 1099-MISC.[3] Within Form 1099-MISC, you have two further choices:  Box 3 or Box 7.  Box 3 is for “other income,” including taxable damage awards.  Box 7 is for “non-employee compensation” over $600.


Suppose you settle your case for $100,000.  You pay your attorney $40,000.  Of the remaining $60,000, you and your accountant or tax adviser decide to allocate $20,000 to wage loss and $40,000 to emotional distress.

Settlement of Claims for Unpaid Wages or Severance

For the wage loss portion:  choose between W-2 or 1099/Box 7
  • If you choose W-2: the employer will treat the payment as if it were a payroll check, and will deduct applicable taxes and withholding for Social Security and Medicare (FICA taxes).  The Defendant will also have to remit the matching taxes equal to 7.65% of the gross wages.
  • If you choose Form 1099-MISC, Box 7:  the employer will cut a check to you in the full amount of $20,000, without deductions for state, federal, or FICA taxes. However, the employer will not pay any portion of your tax or any matching FICA taxes.  At the end of the year, your will receive a 1099 with $20,000 reported in Box 7.

In the Form 1099-MISC scenario, if the amounts received are for settlement of a claim for services, you will be in the same position tax wise as if you were self-employed or had worked for the employer as an independent contractor.  This means that you will be on the hook for all of the FICA taxes, including the employer’s 7.65%.  You must also make estimates of state and federal income taxes and pay them when required, since they were not withheld.

Lesson: Receiving a lump sum for the full amount may not save you taxes and could cost you.

Settlement of Claims for Emotional Distress

For the emotional-distress damages portion:  The only choice here is to have this portion of the settlement paid via a separate check and reported in Box 3 of Form 1099-MISC.  This box is for “other income” and is specifically designed for taxable damage awards.  In short, you don’t want to pay employment-type taxes on the portion of your settlement that is not for wages.

You can ask in the settlement agreement that this payment be reported in Box 3 of the Form 1099-MISC.  If the settlement agreement says only that this payment should be reported on 1099, the employer may mistakenly report it in Box 7, resulting in self-employment taxes.

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What if I am a high wage earner? Does the analysis change?

Employees and employers only pay Social Security taxes on a portion of their wages, being the amount over $98,600 in 2007.  If you earned $100,000 that year, you paid Social Security taxes on the first $98,600 of your salary.  

           Example: Suppose you settled your age-discrimination case with your former employer for $100,000 in a year in which you earned $120,000 in a new job.  Of this, $40,000 goes to your attorney, a hero. Assume that you allocate $20,000 to wage loss and $the remaining 40,000 to liquidated damages, which is a form of payment recoverable in a federal age discrimination case.

            This may be a situation where it would be better to have the $20,000 reported on Form 1099/Box 7.  This is because none of the $20,000 allocated to wage loss should be subject to Social Security taxes; only Medicare.  The former employer issuing the W-2 may mistakenly deduct Social Security taxes from this amount, resulting in an over withholding.

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What if an insurance company, and not my employer, pays most of the settlement?

Some employers buy insurance against discrimination claims. In those cases, the insurance company typically defends the lawsuit and pays the settlement amount above an employer deductible.

Because the insurance company did not employ you, it is not in a position to issue a W-2 to you for amounts allocated to wage loss. Therefore, if some of the settlement is for proceeds, consider allocating that amount to wage loss so that the employer will make that payment, issue the W-2 and, ideally, pay its portion of the FICA amount.

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How should I handle payment of my Attorneys' Fees?

The IRS has regulations for reporting payments made to attorneys.  The regulations simplify the rules about when a payor (such as a defendant-employer paying a settlement) must report a payment made to an attorney.  Now, all payments to attorneys must be reported, even where the attorney did not provide legal services to the payor.

While reporting is mandatory, you and the employer have options on how the settlement checks should be issued:  jointly to you and your attorney, or by separate checks to you and your attorney.


  1. One check, made out joint, example where settlement taxable to Client:  Client sues Employer.  Employer and Client settle the case for $300,000.  Settlement is taxable to Client.  Employer writes one check to attorney for $200,000, representing the net amount of the settlement after income and FICA withholding.  Attorney retains $100,000 of the payment as fees, and disburses $100,000 to Client.  Employer must file an information return with respect to Attorney in the amount of $200,000.  Employer must also file an information return with respect to Client in the amount of $300,000.

  2. One check, made out joint, example where settlement not taxable to Client:  Same example as above, but settlement is not taxable to Client because it is for personal physical injuries.  Employer writes check payable jointly to Client and Attorney, and delivers the check to Attorney.  Attorney keeps $120,000 for fees, and disburses $180,000 to Client.  Employer must file an information return with respect to Attorney for $300,000.  Employer does not file any information return with respect to Client because damages are tax-free.

  3. Separate checks, settlement taxable to Client:  Client sues Employer for discrimination; suit is settled for $300,000.  Settlement is taxable to Client.  Attorney has Employer write two checks, one to Attorney for $100,000 as fees, and one to Client in the amount of $200,000.  Employer files an informational report as to Attorney for $100,000.  Employer files an information return with respect to Client for $300,000.

The moral of the story here is that, if you have the Defendant-employer issue one check made out jointly to you and your attorney, your attorney will receive a 1099 showing the entire amount of the check, even though he or she disbursed most of it to you. Your attorney will therefore prefer a check made jointly to both of you, which the lawyer can then properly account for.

If you prefer to receive a 1099 from the Defendant in the actual amount of the attorney fee, then you should have separate checks cut.

Because Defendants are now sending us 1099s, I keep a filled-out Form W-9 on hand to provide with the signed settlement agreement.  Form W-9 is a request for taxpayer ID number, and you use it to provide the payor with your Social Security Number, or the TIN of your firm.

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The employer sent me a 1099 that included everything, including what my attorney's fee. Do I have to pay taxes on that?

Going back to our example, of the $100,000, $40,000 is your attorney's fee, $20,000 was for lost wages and $40,000 was for emotional distress, with no physical injury.  The employer issued a W-2 for the lost wages, leaving $80,000 for a 1099. Even though you did not see the $40,000 that went to the attorney, the employer must report all $80,000 in Box 3 of a 1099. You must also report the entire $80,000 as income.  

You do not have to pay taxes on the attorney fee amount.  Instead, you have an “above-the-line” reduction in your gross income of $40,000 for the attorney's fee.  On Form 1040, line 36 is for “write-in” adjustments.  This way, you do not pay taxes on the attorney fee amount.  

This above the line reduction for payment to attorneys is only available for “unlawful discrimination claims.”  The definition of what kinds of cases are covered is contained in 26 U.S.C. § 62(e). This Code section is actually very broad and covers a wide spectrum of federal claims, and even state claims, including public-policy claims.

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My employer is willing to agree to my proposed allocations, but it wants me to

You should resist indemnification, which is a promise to reimburse the employer for taxes or penalties it incurs as a result of the allocation. If the employer insists, I have used the following language in the past:

Basic language, where the other side doesn’t insist on indemnification: 

The parties understand and agree that they are each responsible for their own respective tax treatment of the payments made to Client and Client’s counsel under this Agreement, with respect to any taxing authority, whether state, local, or federal.

More extensive language, where indemnification became a potential sticking point. Here, you the Client agree to indemnify and hold the employer harmless only where you have failed to pay taxes that you owed.  This language expressly excepts any failure on the employer’s part to pay employment taxes.       

Except as otherwise provided in this Paragraph, Client agrees to be solely responsible for and legally bound to make payment of the taxes, if any, which are determined to be owed by Client (including penalties and interest related thereto) by any taxing authority on the payments referred to above.   

Except as otherwise provided in this Release, Client agrees and understands that Employer has not made any representations regarding the tax treatment of the sums paid pursuant to this Release, and Client agrees that she is responsible for determining the tax consequences of such payment and for paying taxes, if any, that may be owed by Client with respect to such payment.   

In the event a claim for such taxes, and/or penalties and interest, is asserted by any taxing authority as a result of Client’s failure to pay any taxes Client has been determined to owe, and except as otherwise provided in this Paragraph, Client agrees to, and hereby indemnifies and holds Employer harmless against any and all tax liability, interest, and/or penalties as may be due as a result of Client’s failure to pay any taxes Client has been determined to owe as a result of the payments referenced above.  Nothing herein shall be construed to render Client responsible for any employment taxes, insurance, or related payments subsequently determined to be the sole responsibility of Employer.

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Where can I find more information?

The IRS website ( is actually a very useful place.  You can get .pdf files of all of the IRS forms, as well as the instructions for the forms.  You can also download .pdf files of various IRS publications (such as Publication 525 on taxable income; there is also one specific to back pay), which can be very helpful to explain how things work. You can also consult with your tax adviser or attorney.

As a general rule, do not go to your employment attorney for tax advice. I wrote the original article on taxation of settlements as a general guide for other employment attorneys. They look to tax attorneys and tax professionals, as should you.

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[1] IRS Publication 525 also provides useful information on what is, and is not, taxable income.

[2] E.g., Bagley v. Commissioner, 105 T.C. 396, 406 (1995), aff’d 121 F.3d 393 (8th Cir. 1997); Robinson v. Commissioner, 102 T.C. 116, 127 (1994), aff’d in part, rev’d in part and remanded on other grounds 70 F.3d 34 (5th Cir. 1995); Threlkeld v. Commissioner, 87 T.C. 1294, 1306-1307 (1986), aff’d 848 F.2d 81 (6th Cir. 1988).

[3] A copy of the 1099-MISC is attached to these materials.  See also Instructions for Form 1099-MISC.

[4] Taken from 26 C.F.R. § 1.6045-5.

[5] See Instructions to Form 1040 and Form 1040 itself.

[6] This definition is on the IRS website.

[7] See Murphy v. Internal Revenue Service, 493 F.3d 170 (D.C. Cir. 2007), rev’g 460 F.3d 79 (D.C. Cir. 2006).  See also GJ Stillson MacDonnell & William Hays Weissman, D.C. Circuit Reverses Course and Finds Emotional Distress Damages are Subject to Income Tax, available at  This was published as an e-newsletter specific to employment taxes.

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