Are Sexual Harassment Settlements Taxable? A Straightforward Guide

You're here because you, or someone you know, has gone through the traumatic experience of sexual harassment. And now there's a potential settlement on the table. But, you're wondering - is this settlement going to be taxed? It's a fair question, and one that deserves a clear answer.We'll break it all down for you in this guide. No beating around the bush, just the facts you need to understand the tax implications of a sexual harassment settlement. Let's dive in.

The Basics: What is Considered Taxable Income?

Before we get into the specifics of sexual harassment settlements, let's quickly go over what counts as taxable income. According to the IRS, you generally need to pay taxes on all types of income, including:

• Wages, salaries, tips, etc.
• Interest earned
• Dividends
• Capital gains
• Retirement distributions
• Rental income
• Alimony
• Prizes and awards

The list goes on, but you get the idea. Essentially, any money you receive is considered taxable income unless it's specifically exempted under the tax code.1

Are Sexual Harassment Settlements Taxable? It Depends

Here's where things get a bit tricky. Whether your sexual harassment settlement is taxable or not largely depends on what the payment is for. Let's look at two common scenarios: Scenario 1: Payment for Physical Injuries If your settlement compensates you for physical injuries resulting from the harassment, that portion is generally not taxable.2 This could include things like:

• Medical expenses for injuries
• Pain and suffering from physical trauma
• Emotional distress directly caused by physical injuries

The key here is that the payment must be for observable bodily harm. Purely emotional distress without any physical injuries would likely be taxable. Scenario 2: Payment for Emotional Distress/Other Non-Physical Harm If your settlement compensates for emotional distress, lost wages, punitive damages, or other non-physical harm, that portion is usually considered taxable income.3Some examples:

• Payment for anxiety, depression, PTSD from the harassment
• Back pay or future earnings you would have received
• Attorney's fees (unless you deduct them as an expense)
• Punitive damages meant to punish the perpetrator

So in many cases, sexual harassment settlements end up being split - part non-taxable for physical injuries, and part taxable for emotional/other damages.

How to Handle a Split Settlement

Let's say your $500,000 settlement breaks down like this:

• $200,000 for medical bills and physical injuries
• $300,000 for emotional distress, lost wages, and punitive damages

In this case, you would only pay taxes on the $300,000 portion considered taxable income. But, you can't just deduct the $200,000 from the total - you need to properly allocate the settlement.4The IRS wants to see a reasonable allocation based on the facts of your case. Your attorney should break this down for you, specifying what each payment covers. If the numbers seem way off (like $1 for physical injuries and $499,999 for "emotional distress"), the IRS may challenge it.So make sure you have a well-documented, logical allocation that stands up to scrutiny. This protects you from potential audits and penalties down the road.

Deducting Attorney's Fees

One piece of good news - you may be able to deduct your attorney's fees and legal costs as an expense, even if part of your settlement is taxable.5 This could provide some tax savings.However, there are some important limitations:

• Legal fees are only deductible for the taxable portion of your settlement
• You must itemize deductions rather than taking the standard deduction
• Legal fees are considered a "miscellaneous deduction" subject to a 2% AGI floor

That last one is a biggie. It means you can only deduct legal fees that exceed 2% of your adjusted gross income for the year.Let's look at an example:

• Your AGI for the year is $75,000
• You had $25,000 in legal fees related to the taxable portion of your settlement
• 2% of $75,000 is $1,500
• You can deduct $23,500 ($25,000 - $1,500) in legal fees

So while legal fees are deductible, the 2% AGI floor means you may not get the full tax benefit unless your fees are quite high compared to your income.

Settlements With NDAs - The Tax Cuts and Jobs Act Impact

Here's an important change you need to be aware of if your settlement involves a non-disclosure agreement (NDA).Prior to 2018, companies could generally deduct settlement payments and related fees like legal costs as business expenses. But the Tax Cuts and Jobs Act eliminated this deduction for settlements involving sexual harassment or abuse if the payment is subject to an NDA.6What does this mean for you as the recipient? Well, it doesn't directly impact whether your settlement is taxable or not. But it could make companies more reluctant to include confidentiality clauses, since they can no longer deduct those payments.Some may try to allocate more of the settlement as non-taxable "physical injury" damages to avoid the NDA deduction disallowance. So you may see more aggressive allocations that the IRS could scrutinize.The bottom line? Be aware of this change, as it could affect settlement negotiations and allocations. But your main focus should still be ensuring your settlement is properly allocated between taxable and non-taxable damages.

Reporting Taxable Settlement Income

If part of your settlement is taxable, you'll need to report it as "Other Income" on your Form 1040 tax return for the year you received it.7 The payer should also send you a Form 1099-MISC showing the taxable amount in Box 3.Don't just put the full settlement amount on your return. Remember, you only pay taxes on the taxable portion after allocating for things like physical injuries. Having documentation of how the settlement breaks down is crucial.You'll then calculate how much tax you owe on the taxable amount based on your total taxable income and filing status for the year.

When to Hire a Tax Professional

While the tax treatment of sexual harassment settlements follows some general rules, every case is different. The facts, allocation of damages, and specific settlement terms can significantly impact the tax implications.For many people, it makes sense to hire a tax professional or Certified Public Accountant (CPA) who understands this complex area of tax law. They can:

• Review your settlement details and allocation
• Ensure you are reporting and paying the proper amount of tax
• Identify any potential deductions or tax savings opportunities
• Advise you on structuring the settlement in a tax-efficient manner
• Represent you in the event of an IRS inquiry or audit

An experienced tax pro can give you peace of mind that you are handling your settlement taxes correctly and not overpaying or underpaying the IRS.The tax implications of a sexual harassment settlement are hardly straightforward. But, with some guidance and careful allocation between taxable and non-taxable damages, you can ensure you are meeting your tax obligations properly.

Key Takeaways

Let's quickly recap the main points:

• Damages for physical injuries are generally not taxable
• Damages for emotional distress, lost wages, punitive damages are taxable
• Settlements are often split between taxable and non-taxable portions
• You need to reasonably allocate the settlement based on the facts
• Legal fees for the taxable portion may be deductible (subject to limits)
• Settlements with NDAs may face more IRS scrutiny on allocations
• Report taxable settlement amounts as "Other Income" on your tax return
• Consider hiring a tax pro to ensure proper tax compliance

Sexual harassment settlements are complex enough without having to decipher the tax code on your own. But, understanding the basic tax rules can help ensure you aren't overpaying taxes on your settlement.