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Tax relief for employment plaintiffs: it used to be that winning a job discrimination case was actually a losing proposition for many plaintiffs after factoring in the income tax costs. Recent changes in the law may help some clients.

Article Excerpt
One would think that paying income taxes on a recovery would be better than receiving no recovery at all. But for some plaintiffs, these taxes--the calculation of which often prohibits taking into account a deduction for attorney fees--can entirely consume and even exceed the amount that they received. (1)

Recent developments have significantly changed the taxation of some types of recoveries and the fees plaintiffs pay to their attorneys. Still true, however, is this basic principle: All income is taxable, unless specifically excluded. (2) If you win the lottery, plan to give a big chunk back because it's taxable income. Find buffed treasure in your backyard, it's taxable income. Sue your boss for sexual harassment and obtain a judgment or settlement, that too is taxable income.

But there are exceptions to this general rule, and plaintiff attorneys would be wise to secure professional tax advice to help ensure the best possible tax outcomes for their clients.

Under this basic rule, plaintiffs' settlement proceeds and damages awards are generally taxable, and attorney fees related to securing the recovery are generally deductible as expenses for the production of income. (3) Taxable income (or "gross income" as it is called under the Internal Revenue Code) does not include the amount of any damages, other than punitive damages, received (whether by suit or agreement and whether as lump sums or as periodic payments) on "account of personal physical injury or physical sickness." (4) Attorney fees paid from these recoveries are not deductible--under the theory that all the income was tax free to begin with. (5)

The requirement of a physical injury or physical sickness is key. Before passage of the Small Business Job Protection Act of 1996, the income exclusion applied to recoveries for "personal" injuries, which included nonphysical injuries like purely mental pain and suffering. (6) Now, the exclusion applies only to recoveries for claims made on account of a "physical" injury or sickness. (7) Consequently, damages awarded for an emotional distress claim are tax free only if the claim was made on account of a physical injury or sickness. (8)

This is true even if the recipient of the recovery is not the physically injured party. For example, loss-of-consortium damages based on a spouse's physical injury are tax free. (9)

Another interesting policy twist is the treatment of recoveries for lost wages. Ordinarily, a settlement or award for lost wages is considered taxable income. Remember the general rule: All recoveries are taxable unless specifically excluded. However, even though the wages would have been taxable when earned, if the compensation for lost wages was on account of a physical injury or physical sickness, the recovery is excluded from taxable income. (10)

What to deduct?

Until recently, the circuits were...

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