“There is nothing certain in life except death and taxes.” That observation is most commonly attributed to Benjamin Franklin, and it remains just as true when an employment dispute finally resolves. While a settlement or judgment may bring long-awaited closure and financial relief, it also brings an unavoidable economic reality: a portion of the recovery will often be subject to federal and state income taxation, sometimes in ways that surprise even experienced practitioners.
When employment cases resolve through settlement or judgment, the tax consequences can significantly affect a plaintiff’s net recovery. Many employees are surprised to learn that large portions of a settlement may be taxable and that tax liability can arise even on funds the employee never personally receives. Understanding how federal and California tax law treat different categories of damages, and how attorney fees are handled, is essential.
The Starting Point: Gross Income Is Broadly Defined
Federal tax law begins with a broad presumption. Under the Internal Revenue Code, gross income includes “all income from whatever source derived,” unless a specific statutory exclusion applies. As a result, settlement proceeds are generally taxable unless the taxpayer can point to a clear exception. California tax law largely conforms to this federal framework, meaning that amounts taxable at the federal level are usually taxable for California income tax purposes as well.
To determine taxability, courts and the IRS focus on the origin of the claim. The critical question is what the settlement payment is intended to replace. If the settlement substitutes for income that would have been taxable if earned in the normal course of employment, the payment is typically taxable when received as part of a settlement or judgment.
General Damages: Emotional Distress and Non-Physical Injuries
In employment cases, general damages often include compensation for emotional distress, mental anguish, humiliation, or reputational harm. Under current federal law, damages for emotional distress are generally taxable unless they arise directly from a physical injury or physical sickness. Emotional distress damages tied to discrimination, harassment, retaliation, or wrongful termination, without an accompanying physical injury, do not qualify for exclusion from income.
There is a limited exception for amounts paid to reimburse medical expenses attributable to emotional distress, but that exclusion is narrow and depends heavily on the underlying facts. California follows the same general approach, treating emotional distress damages as taxable unless they are directly connected to physical injury or sickness.
Special Damages: Wages, Penalties, and Economic Losses
Special damages in employment settlements are almost always taxable. These include unpaid wages, back pay, front pay, lost past or future earnings, statutory penalties, and interest. Because these amounts replace compensation or economic benefits the employee would have received absent the alleged wrongdoing, they are treated as income for tax purposes.
Wage components of a settlement are typically reported on a Form W-2 and are subject to income tax withholding and payroll taxes. Other taxable components, such as penalties, interest, or non-wage damages, are commonly reported on Form 1099-MISC. California generally mirrors this treatment for state income tax purposes.
Punitive damages, when awarded, are fully taxable under both federal and California law, regardless of the nature of the underlying claim.
Attorney Fees and the U.S. Supreme Court’s Decision in Commissioner v. Banks
A critical and often misunderstood aspect of settlement taxation involves attorney fees. Many plaintiffs assume that the portion of a settlement paid to their attorney should not be taxable to them, particularly where the defendant employer issues the attorney-fee payment directly to counsel. That assumption is understandable, but under current law it is usually incorrect.
In Commissioner v. Banks, 543 U.S. 426 (2005), the United States Supreme Court squarely addressed this issue. The Court held that when a lawsuit recovery constitutes taxable income, the plaintiff must include in gross income the entire recovery, including any portion paid directly to the plaintiff’s attorney under a contingent-fee agreement. The Court relied on long-standing assignment-of-income and agency principles, explaining that the attorney acts as the client’s agent and that directing payment to counsel does not change the tax character of the recovery.
As the Court explained, “The attorney is an agent who is duty bound to act only in the interests of the principal, and so it is appropriate to treat the full amount of the recovery as income to the principal.” The fact that the plaintiff never physically receives the attorney-fee portion does not alter this result. For tax purposes, the plaintiff is treated as having constructively received the full amount and then used part of it to satisfy a contractual obligation to counsel.
Direct-to-Attorney Payments Do Not Change the Tax Result
This principle has direct consequences in employment settlements where the agreement allocates a portion of the total settlement to attorney fees and provides that those fees will be paid directly to counsel. While this arrangement may simplify payment logistics, it does not reduce the plaintiff’s taxable income if the underlying recovery is taxable.
If a settlement includes taxable components such as unpaid wages, emotional distress damages unrelated to physical injury, statutory penalties, or interest, the plaintiff is treated as receiving the full taxable amount even if the attorney’s share is paid separately and never passes through the plaintiff’s hands. Under current law, many plaintiffs cannot deduct attorney fees, which can result in tax being owed on money the plaintiff never actually receives.
Information Reporting and the Role of Multiple Tax Forms
Defendants frequently issue multiple information returns in employment settlements. When a settlement includes taxable non-wage damages, the employer will typically issue a Form 1099-MISC to the employee reporting the full taxable amount, including the attorney-fee portion. Separately, the employer is generally required to issue a Form 1099-NEC to the plaintiff’s attorney reporting the legal fees paid.
If part of the settlement represents wages, that portion must usually be reported on a Form W-2 and is subject to payroll tax withholding, even if the employer simultaneously issues a Form 1099-NEC to the attorney. The routing of the check does not change the tax character of the payment or the employer’s reporting obligations.
This framework sometimes leads plaintiffs to believe that attorney fees are being taxed twice. In a practical sense, that is not the case. The plaintiff is taxed on the gross recovery because the law treats the recovery as the plaintiff’s income. Separately, the attorney is taxed on the professional fees earned for legal services, just like any other compensation for advocacy or professional work.
Why The Government Does Not View This as “Double Taxation” of Attorney Fees
Each party is taxed on income attributed to them under long-established tax principles. While the economic impact can feel harsh, particularly for plaintiffs who can deduct attorney fees in onlky specific cases, the result reflects how the tax code allocates income between clients and their attorneys.
The Limited Above-the-Line Deduction for Attorney Fees Under IRC § 62(a)(20) and (21)
Although the general rule is that attorney fees in employment cases are not deductible, Congress created a narrow and important exception that can apply in certain cases. Under Internal Revenue Code section 62(a)(20) and (21), some plaintiffs may deduct attorney fees “above the line,” meaning the deduction is taken in computing adjusted gross income rather than as an itemized deduction. This exception was enacted to mitigate the harsh result of taxing plaintiffs on the full recovery while denying any deduction for legal fees in certain statutorily protected cases.
This above-the-line deduction is available only for attorney fees incurred in connection with specific types of claims. The statute applies to actions involving “unlawful discrimination,” as well as certain whistleblower claims. The term “unlawful discrimination” is defined by reference to an enumerated list of federal, state, and local laws that prohibit discrimination or retaliation. These include, among others, Title VII of the Civil Rights Act, the Americans with Disabilities Act, the Age Discrimination in Employment Act, and comparable state statutes such as California’s Fair Employment and Housing Act. Retaliation claims brought under these laws are also covered.
Importantly, this exception does not apply to all employment claims. Pure wage-and-hour disputes, breach of contract claims, common-law tort claims, or statutory penalty claims that are not tied to unlawful discrimination or whistleblower protection generally do not qualify. As a result, many employment settlements remain fully taxable with no deduction for attorney fees, even though the employee is taxed on the gross recovery under Commissioner v. Banks.
Even when the exception applies, the deduction is limited in scope. The attorney-fee deduction is capped at the amount of taxable income attributable to the qualifying claim. Fees allocable to non-taxable recoveries do not generate a deduction, because no income was included in the first place. In cases resolving multiple claims, allocation may be necessary to determine what portion of the attorney fees, if any, qualifies for above-the-line treatment.
The deduction does not change the fundamental income-inclusion rule. Under Commissioner v. Banks, the plaintiff must still include the full amount of the taxable recovery in gross income, including attorney fees paid directly to counsel. The deduction under IRC § 62(a)(20) or (21) operates only as an adjustment to income, not as an exclusion, and it applies only if the statutory requirements are satisfied.
Planning Ahead: Taxes as an Unavoidable Settlement Reality
Because income taxes are an unavoidable part of settlement economics in every case, and everyone must pay their taxes, plaintiffs should plan for tax consequences before spending settlement funds they receive. Allocation language in settlement agreements, anticipated tax reporting, estimated tax payments, and cash-flow considerations should be discussed with qualified tax professionals. Thoughtful planning cannot eliminate taxes where the law requires inclusion in income, but it can help avoid unpleasant surprises and allow plaintiffs to make informed decisions about settlement offers.
Not Tax Advice
This communication is not written or intended as tax advice or an opinion. It is provided for general informational purposes only. Taxpayers should consult their own tax advisors regarding the application of tax law to their specific circumstances.