As awards for back wages are often connected with a personal injury that interfered with the employee taxpayer’s earning capacity, understanding the distinction between awards for back wages and their personal injury award counterparts is crucial.  The key difference between awards for back wages and personal injury awards is that awards for back wages are subject to federal taxation, while personal injury awards are excluded from federal taxation.

Unless the injury is physical, any settlement or award is taxable. That makes awards for discrimination, emotional distress and/or injury fully taxable — even though these awards are intended only to make you whole again.

For a verdict or settlement to be tax-free, it must be structured to meet two Internal Revenue Code requirements:

A physical injury or illness must have occurred. Without either, the proceeds will clearly be taxable.

The injury or illness must be the result of a tort — a wrongful act, injury or action. If you successfully sue someone who hit your car, the award will be tax-free. But if you win a back pay judgment from a breach of contract suit, the award is taxable income. It resulted from a contract dispute.

Neil Johnson
www.thetaxdude.com
taxdude@covad.net

IRS Code Section 104

Compensation for injuries or sickness

(a) In general except in the case of amounts attributable to (and not in excess

of) deductions allowed under section 213(relating to medical, etc., expenses)

for any prior taxable year, gross income does not include –

(1) amounts received under workmen’s compensation acts as

compensation for personal injuries or sickness;

(2) 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;

(3) amounts received through accident or health insurance (or through

an arrangement having the effect of accident or health insurance) for

personal injuries or sickness (other than amounts received by an

employee, to the extent such amounts (A) are attributable to

contributions by the employer which were not includible in the gross

income of the employee, or (B) are paid by the employer);

(4) amounts received as a pension, annuity, or similar allowance for

personal injuries or sickness resulting from active service in the armed

forces of any country or in the Coast and Geodetic Survey or the Public

Health Service, or as a disability annuity payable under the provisions

of section 808 of the Foreign Service Act of 1980; and

(5) amounts received by an individual as disability income attributable

to injuries incurred as a direct result of a violent attack which the

Secretary of State determines to be a terrorist attack and which

occurred while such individual was an employee of the United States

engaged in the performance of his official duties outside the United

States. For purposes of paragraph (3), in the case of an individual who

is, or has been, an employee within the meaning of section 401(c)(1)

(relating to self-employed individuals), contributions made on behalf of

such individual while he was such an employee to a trust described in

section 401(a) which is exempt from tax under section 501(a), or under

a plan described in section 403(a), shall, to the extent allowed as

deductions under section 404, be treated as contributions by the

employer which were not includible in the gross income of the

employee. For purposes of paragraph (2), emotional distress shall not

be treated as a physical injury or physical sickness. The preceding

sentence shall not apply to an amount of damages not in excess of the

amount paid for medical care (described in subparagraph (A) or (B) of

section 213(d)(1)) attributable to emotional distress.

(b) Termination of application of subsection (a)(4) in certain cases

(1) In general Subsection (a)(4) shall not apply in the case of any

individual who is not described in paragraph (2).

(2) Individuals to whom subsection (a)(4) continues to apply An

individual is described in this paragraph if –

(A) on or before September 24, 1975, he was entitled to receive

any amount described in subsection (a)(4),

(B) on September 24, 1975, he was a member of any organization

(or reserve component thereof) referred to in subsection (a)(4) or

under a binding written commitment to become such a member,

(C) he receives an amount described in subsection (a)(4) by

reason of a combat-related injury, or

(D) on application therefore, he would be entitled to receive

disability compensation from the Veterans’ Administration.

(3) Special rules for combat-related injuries For purposes of this

subsection, the term ”combat-related injury” means personal injury or

sickness –

(A) which is incurred –

(i) as a direct result of armed conflict,

(ii) while engaged in extra hazardous service, or

(iii) under conditions simulating war; or

(B) which is caused by an instrumentality of war. In the case of

an individual who is not described in subparagraph (A) or (B) of

paragraph (2), except as provided in paragraph (4), the only

amounts taken into account under subsection (a)(4) shall be the

amounts which he receives by reason of a combat-related injury.

(4) Amount excluded to be not less than veterans’ disability

compensation In the case of any individual described in paragraph (2),

the amounts excludable under subsection (a)(4) for any period with

respect to any individual shall not be less than the maximum amount

which such individual, on application therefor, would be entitled to

receive as disability compensation from the Veterans’ Administration.

(c) Application of prior law in certain cases The phrase ”(other than punitive

damages)” shall not apply to punitive damages awarded in a civil action –

(1) which is a wrongful death action, and

(2) with respect to which applicable State law (as in effect on

September 13, 1995 and without regard to any modification after such

date) provides, or has been construed to provide by a court of

competent jurisdiction pursuant to a decision issued on or before

September 13, 1995, that only punitive damages may be awarded in

such an action. This subsection shall cease to apply to any civil action

filed on or after the first date on which the applicable State law ceases

to provide (or is no longer construed to provide) the treatment

described in paragraph (2).

(d) Cross references

(1) For exclusion from employee’s gross income of employer

contributions to accident and health plans, see section 106.

(2) For exclusion of part of disability retirement pay from the application

of subsection (a)(4) of this section, see section 1403 of title 10, United

States Code (relating to career compensation laws).

Legal Notice per Rules of Professional Responsibility: The Rhode Island Supreme Court licenses all lawyers and attorneys in the general practice of law, but does not license or certify any lawyer / attorney as an expert or specialist in any field of practice. While this firm maintains joint responsibility, most cases of this type are referred to other attorneys for principle responsibility.