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.
Reporting Unpaid Wages
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. 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 – even if it was earned in a prior year.
Other Settlement Awards
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.
Employment Taxes & Withholding
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 wage settlements like regular employment compensation, and therefore, requires employers to withhold employment taxes, such as Social Security and Medicare, from the payment.
Deducting Legal Fees
In the event you hire an attorney to handle your employment action, the tax law allows you to reduce the taxable settlement with a deduction for the attorney's fee. If the underlying legal claim alleges any form of prohibited employment discrimination, you get to deduct the legal fees as an adjustment to income – which is beneficial since the deduction directly offsets your income. For all other employment claims, you can deduct the legal fees as a miscellaneous expense if you itemize deductions. But there's a catch to that deduction: You can deduct the total of your miscellaneous expenses only to the extent they exceed 2 percent of your adjusted gross income.