Though many lawsuit settlement proceeds aren’t subject to taxation, those from a wrongful termination suit generally are. The award is based on lost wages and income. Since it effectively replaces taxable earnings, it too is taxed. The exception is for a termination tied to a physical ailment associated with the workplace.
What Gets Taxed
Damages for wages and compensation are subject to both employment and income taxes. It covers lost wages and bonuses, severance pay and other replacement earnings. Punitive damages and emotional damages aren’t subject to employment taxes or the necessary withholding, but are taxed as ordinary income by the Internal Revenue Service. Any claims relating to physical injuries or sickness are not taxable.
The distinction between proceeds related to physical injuries and other types of compensation common in wrongful termination settlements can be significant. If the employee suffered an injury at work that caused the wrongful termination, much of the proceeds related to the lawsuit may be tied to that injury, and therefore not taxable. Such distinctions often are explicitly noted in any settlement or award.