Settlement Agreement Wording Can Determine Tax Treatment

A settlement agreement of a discrimination case can be instrumental in determining its tax treatment.  First, any portion of the settlement agreement is tax exempt to the extent it is for a “personal physical injury” under Internal Revenue Code § 104(a)(2).  For that reason, settlement agreements should make mention of any such personal injuries, as tax exempt status works to the advantage of both the plaintiff and the employer.  That is, plaintiff receives more take-home money and the employer avoids the payment of payroll taxes. 

Second, Internal Revenue Code § 62(a)(20) permits deductions “for attorneys’ fees and court costs paid by, or on behalf of, the taxpayer in connection with any action involving a claim of unlawful discrimination.”  Thus, similar tax advantages can be achieved by allocating a portion of the settlement payment to the payment of plaintiff’s attorneys’ fees.  The bottom line is that for favorable tax treatment, settlement agreements should state how the proceeds are to be allocated.  It is also wise for the settlement agreement to include a provision that the plaintiff is solely responsible for any issues pertaining to the tax treatment of the payment of the proceeds.  Such agreements also generally report such income on an IRS Form 1099.  For a recent tax court case addressing these issues, see Mennemeyer v. Commissioner, T.C. Memo 2025-80.

This article is part of our December 2025 Newsletter. 

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