If you file a lawsuit against your employer and the damages you claim relate to lost or unpaid wages, settling out of court instead of going to trial doesn't change the tax treatment of your employment earnings. Settlements for unpaid wages are taxable, just like the wages you received before the lawsuit. But the settlement payments that aren't related to unpaid wages may be treated differently for tax purposes and potentially allow you to take some deductions.
Settlement payments are taxable as income in the year you receive the payment.
Reporting Unpaid Overtime Settlements
When the underlying lawsuit against your employer doesn't involve physical injury, such as claims based on discrimination and wrongful termination, the portion of the settlement that compensates you for lost or unpaid wages must be reported on your return.
Depending on the facts and circumstances of your case, the settlement may include payments other than wages. For example, your employer may agree to pay interest on the unpaid wages to compensate you for the period of time you didn't have access to the money. Interest is taxable, but it's reported on the “Taxable interest” line of the return. And if you receive an award for emotional distress, it too is taxable, but it's reported on the “Other income” line. When you receive a settlement payment for emotional distress, the Internal Revenue Service lets you reduce the reported amount by the medical expenses you incur treating the distress. You can also reduce it by the medical expenses incurred in prior years for treating the distress if it didn't provide you with any tax benefit at the time. If you do have medical expenses, attach a statement to your return that outlines the settlements and medical expenses as the IRS requires it.
Employers who settle claims out of court have an obligation to report the portion attributed to unpaid wages on a W-2 form and withhold the appropriate amount of income tax. Like the IRS, the Social Security Administration also treats unpaid disability discrimination lawsuit settlements and other wage settlements like regular employment compensation, and therefore, requires employers to withhold employment taxes, such as Social Security and Medicare, from the payment.
2018 Tax Law Changes
Prior to the Tax Cuts and Jobs Act, if you hired an attorney to handle your employment action, the tax law allowed you to deduct the attorney's fee, as long as it exceeded 2 percent of your adjusted gross income. The new law wipes out any miscellaneous deductions while nearly doubling the standard deduction to $12,000.
Filing Your 2017 Taxes
If you're claiming a wage settlement on your 2017 taxes, you will enter the amount on the “Wages, salaries, tips, etc.” line of your Form 1040, 1040A or 1040-EZ. The wages aren't reportable until the year you receive payment – so if you haven't received your payment yet, you can delay until the year you get the money.
- Internal Revenue Service: Publication 4345
- Internal Revenue Service: Publication 957
- Internal Revenue Service: Lawsuits, Awards and Settlements Audit Technique Guide
- Forbes: New Tax On Lawsuit Settlements -- Legal Fees Can't Be Deducted
- Forbes: New: IRS Announces 2018 Tax Rates, Standard Deductions, Exemption Amounts And More