Are Employment Discrimination and Wrongful Termination Settlements Taxable in New York?

A warehouse supervisor in Ronkonkoma complained to human resources about how a manager treated older workers, and was fired two months later. The supervisor brought a retaliation claim under the New York State Human Rights Law, and the employer offered to settle before trial. The draft agreement names one total, lists three kinds of payment, and has a blank where the tax treatment should be. The supervisor’s question is the one most employees ask at this point: how much of this will I actually keep?

The answer turns on what each dollar is paid for. The value of New York employment claims has risen since the 2019 amendments, and the tax question has grown with it. This is general information, not tax advice for any one settlement.

The physical-injury rule, and why most employment claims fall outside it

The exclusion that matters is 26 U.S.C. § 104(a)(2). It excludes “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 injuries or physical sickness.”

The word that does the work is “physical.” Right below that list, the statute adds: “emotional distress shall not be treated as a physical injury or physical sickness.” The one exception is for damages “not in excess of the amount paid for medical care” attributable to emotional distress. Consequently, damages up to what you paid for that care come back tax free; the rest of an emotional distress award is income.

The IRS goes one step further. Publication 525 states that “Emotional distress includes physical symptoms that result from emotional distress, such as headaches, insomnia, and stomach disorders.” Losing sleep for months after a firing is real harm. It is not, for this rule, a physical injury.

The rule runs the other way, too. Publication 4345 treats distress “attributable to a personal physical injury or physical sickness” like the physical injury itself, so an employment case that includes a real physical injury, such as an assault at work, is analyzed differently for that part. That is why most of a car accident settlement is not taxed while most of a discrimination settlement is. Consequently, in the typical discrimination or retaliation case, start from the premise that the money is income, and ask what kind.

Back pay, front pay and severance are wages

Publication 4345 is direct about lost pay. In a settlement “for unlawful discrimination or involuntary termination, the portion of the proceeds that is for lost wages (i.e., severance pay, back pay, front pay) is taxable wages” and subject to Social Security and Medicare tax, and the proceeds are subject “to employment tax withholding by the payer.”

Two consequences follow. The employer withholds from the wage portion, so the check is smaller than the number in the agreement. And the timing follows the payment: Publication 957 states that “for income tax purposes, the IRS treats all back pay as wages in the year paid,” so two years of lost pay can land in one tax year.

Everything else goes on a different form. The Form 1099-MISC instructions tell payers to “report all compensatory damages for nonphysical injuries or sickness, such as employment discrimination or defamation.” Expect two documents from one settlement: a W-2 for the wages and a 1099 for the rest.

What are your damages? That’s the question in every employment case. So you’re going to have lost pay, and you’re going to have emotional distress, and you’re going to have attorney fees. And each one of those dollars is treated differently by the IRS. Back pay and front pay are wages, so the employer withholds on them just like a regular paycheck. Emotional distress money is not for a physical injury, so it’s income too, except what you spent on medical care to treat that emotional distress.

The table below sets out each piece, side by side, with the line of the statute or the IRS publication that governs it.

Almost nothing in a non-physical employment case is excluded from income. The planning happens in the labels and the timing.

Liquidated damages, punitive damages and interest

New York’s retaliation statutes add money beyond lost pay, and none of it is excluded. Retaliation in New York is never one statute.

In the private sector, Labor Law § 215 protects an employee who complains, reasonably and in good faith, that the employer is violating the Labor Law. A court may order reinstatement or front pay, lost compensation, costs and reasonable attorneys’ fees, and “shall award liquidated damages to every employee aggrieved,” in an amount “not more than twenty thousand dollars.” Labor Law § 740, the whistleblower statute, adds lost wages and benefits, front pay, fees, a civil penalty, and “punitive damages, if the violation was willful, malicious or wanton.” A retaliation claim after a discrimination complaint runs under Executive Law § 296(7), and the Human Rights Law allows punitive damages “in cases of employment discrimination related to private employers.”

Each category has its own tax answer. Front pay and lost wages are wages. Liquidated damages are not paid for a physical injury, so the exclusion does not reach them. Punitive damages are carved out of the exclusion in its own text, and Publication 4345 says they are taxable “even if the punitive damages were received in a settlement for personal physical injuries or physical sickness.” Interest is “generally taxable,” and it is not wages.

Consequently, a larger recovery under the retaliation statutes is a larger taxable recovery; plan for it before the money arrives. Our post on the retaliation standard after 2019 explains how those claims are proved.

Attorney fees: taxed on the whole, then deducted

In Commissioner v. Banks, the Supreme Court held “that, as a general rule, when a litigant’s recovery constitutes income, the litigant’s income includes the portion of the recovery paid to the attorney as a contingent fee.” The employee who receives a settlement, part of which goes straight to the lawyer, is generally treated as having received all of it.

Congress answered that problem for discrimination claims. The statute is quoted in full below because the definition decides who gets the benefit.

Read paragraph (18) against the New York statutes. The Human Rights Law prohibits discrimination and retaliation in employment, and the two Labor Law retaliation sections prohibit retaliation against an employee; those claims fit the words “regulating any aspect of the employment relationship” and “prohibiting … retaliation.” Title VII is named outright. Consequently, for most employees in these cases the fee portion goes into income and comes back out above the line, capped at what the settlement put into income that year. Have the preparer confirm that the claim in your complaint is one the statute reaches.

What the settlement agreement’s allocation can and cannot do

The settlement agreement is where the categories get their labels. Publication 4345 describes the practice: “an agreement may include allocations to back pay, emotional distress, and attorneys’ fees. Generally, the IRS will not disturb an allocation if it is consistent with the substance of the settled claims.”

That sentence gives the parties room and sets the limit at once. An allocation that tracks the claims, the pay records and the evidence of distress is the kind the IRS generally leaves alone. Calling lost pay “emotional distress” to avoid withholding, or a non-physical claim “physical injury,” is not consistent with the substance of what was settled. The agreement cannot change what the money replaces.

Don’t sign a release without a lawyer. The settlement agreement says what each payment is for. The IRS generally will not disturb an allocation if it is consistent with the substance of the claims that were settled. It has to be consistent with the case that you had. That’s when you should get tax advice, before you sign, not after the forms come in the mail.

In practice, the allocation paragraph is negotiated like any other term. Ask which payments will carry a W-2 and which a 1099, and how the fee portion will be paid and reported. The choice between an EEOC charge and a New York lawsuit also shapes which statutes the release names, which matters for the fee deduction.

New York State and New York City tax

New York does not start over. Tax Law § 612(a) provides that “The New York adjusted gross income of a resident individual means his federal adjusted gross income as defined in the laws of the United States for the taxable year, with the modifications specified in this section.” None of the modifications in § 612 addresses settlement damages, discrimination claims or attorney fees.

Consequently, what is taxable federally is generally taxable to a New York resident, and the above-the-line fee deduction, because it lowers federal adjusted gross income, carries into the New York starting number. For a New York City resident, Tax Law § 1303 makes city taxable income “the same as his or her New York taxable income,” with one charitable add-back. A Nassau or Suffolk resident who is not a city resident does not compute it at all.

Before you sign

Publication 4345 adds two practical points. A taxable settlement can require estimated tax payments when withholding will not cover the tax, and anyone who buys health coverage through the Marketplace with advance credit payments should report the change in income. Both are about the year the money lands.

New York State law really is on the vanguard of protecting employees’ rights. So since 2019, the settlement value of human rights law claims has gone up by quite a bit, and retaliation claims are heavy claims. A bigger settlement means a bigger tax question. The rules don’t change what it’s worth; they change what you keep.

That is my view, not a forecast about any one settlement. The tax rules are the ones quoted above, and a tax professional who sees the draft agreement can apply them to your year.

Back to the supervisor in Ronkonkoma

The supervisor’s draft agreement lists three payments. The lost-pay piece is wages: the employer withholds, Social Security and Medicare apply, and it arrives on a W-2 in the year it is paid. The emotional distress piece is income on a 1099, reduced by what the supervisor paid for counseling and never deducted. The fee piece is the supervisor’s income under Banks, and because a Human Rights Law retaliation claim fits the words of § 62(e)(18), the supervisor should be able to deduct it above the line, up to what the settlement put into income that year.

The time to see the net is before the signature. Our wrongful termination practice and retaliation practice handle the claim; a tax professional handles the return.

Sources

• 26 U.S.C. § 104, Compensation for injuries or sickness
• 26 U.S.C. § 62, Adjusted gross income defined (subsections (a)(20) and (e))
• IRS Publication 4345, Settlements: Taxability
• IRS Publication 525, Taxable and Nontaxable Income
• IRS Publication 957, Reporting Back Pay and Special Wage Payments to the Social Security Administration
• IRS Instructions for Forms 1099-MISC and 1099-NEC
• Commissioner v. Banks, 543 U.S. 426 (2005)
• New York Tax Law § 612, New York adjusted gross income of a resident individual
• New York Tax Law § 1303, City taxable income
• New York Tax Law § 1305, City resident and city nonresident defined
• Executive Law § 296, Unlawful discriminatory practices
• Executive Law § 297, Procedure
• Labor Law § 215, Penalties and civil action; prohibited retaliation
• Labor Law § 740, Retaliatory action by employers

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The supervisor’s settlement was never one number. It was three, each with its own tax rule, and the agreement decided which was which. Our employment law practice reviews the claim and the release before anything is signed.

If your employer has offered to settle a discrimination, retaliation or wrongful termination claim, call (516) 750-0595 with the draft agreement in hand, or request a free case review.