Employment Discrimination Awards: Almost Always Taxable—Here’s Why
Unlike personal injury settlements involving physical harm, damages recovered in employment discrimination cases are generally fully taxable, even when they include compensation for emotional distress. This critical distinction stems from a 1996 amendment to the tax code that fundamentally reshaped what qualifies for tax-free treatment.
The Core Rule: “Physical Injury or Sickness” Required
IRC § 104(a)(2) excludes from gross income damages received “on account of personal physical injuries or physical sickness.” The key phrase is “physical.”
Employment discrimination claims—whether based on race, age, gender, religion, disability, or national origin under Title VII, the ADEA, ADA, or similar statutes—typically involve:
- Back pay and front pay (lost wages)
- Compensatory damages for emotional distress, humiliation, or reputational harm
- Punitive damages
- Liquidated damages (under statutes like the ADEA)
None of these are excludable under § 104(a)(2) because discrimination itself is not a physical injury. The emotional distress flowing from workplace discrimination is treated as a non-physical personal injury—and therefore taxable.
Revenue Ruling 96-65: The IRS Draws a Bright Line
Rev. Rul. 96-65, 1996-2 C.B. 6 provides definitive guidance:
“Back pay received in satisfaction of a claim for denial of a promotion due to disparate treatment employment discrimination under Title VII is not excludable from gross income under section 104(a)(2) because it is completely independent of, and thus is not damages received on account of, personal physical injuries or physical sickness.”
The ruling further clarifies that emotional distress damages are taxable—except to the limited extent they reimburse actual medical expenses for treating that distress (e.g., therapy, counseling, medication) under IRC § 213(d).
Example:
- $100,000 settlement for emotional distress from wrongful termination → $100,000 taxable
- Minus $8,000 paid to therapists/psychiatrists → $8,000 potentially excludable
- Net taxable amount: $92,000
The Schleier Decision and Grandfathering Rule
The Supreme Court’s 1995 decision in Commissioner v. Schleier, 515 U.S. 323, held that age discrimination recoveries were taxable because they didn’t arise from “tort or tort-type rights” in the traditional sense. Congress then codified and expanded this principle in the 1996 amendment.
Rev. Rul. 96-65 includes a limited grandfathering provision (under IRC § 7805(b) relief):
Damages received under employment discrimination claims may still be excludable if they were received:
- On or before June 14, 1995 (the date Schleier was decided), OR
- Pursuant to a written binding agreement, court decree, or mediation award in effect on or before June 14, 1995
This relief applies regardless of when payment was actually made—as long as the binding resolution existed before the Schleier decision.
Critical Distinction: Physical Injury vs. Discrimination
| Scenario | Tax Treatment |
|---|---|
| Car accident causing broken bones → $200K settlement for medical bills, pain, lost wages | ✅ Excludable (physical injury) |
| Workplace harassment causing anxiety/depression → $200K settlement for emotional distress | ❌ Taxable (non-physical injury) |
| Same harassment also causes stress-induced ulcer requiring hospitalization → $50K for ulcer treatment | ⚠️ Only medical costs excludable; emotional distress portion remains taxable |
Key takeaway: The presence of some physical manifestation (e.g., stress-induced illness) doesn’t automatically make the entire recovery tax-free. Only amounts specifically paid for medical care related to physical sickness may qualify for exclusion—and even then, documentation is essential.
Practical Tips for Settlement Negotiations
- Don’t assume emotional distress = tax-free. Unlike physical injury cases, it generally isn’t.
- Document medical expenses meticulously. If you seek exclusion for therapy/counseling costs, keep detailed records linking payments to treatment for distress arising from the discrimination.
- Consider tax consequences upfront. A $500,000 taxable settlement may net less after tax than a $400,000 physical injury settlement that’s fully excludable.
- Review pre-June 1995 agreements carefully. If your claim was resolved before Schleier, you may qualify for grandfathered treatment.
Bottom Line
Employment discrimination recoveries = taxable income
Physical injury recoveries = generally tax-free (except punitive damages)
The tax code draws a sharp line between these two categories. Understanding where your case falls—and planning accordingly—can save you significant tax liability and avoid painful surprises come April 15.
Disclaimer: This article is for informational purposes only and does not constitute tax or legal advice. Employment discrimination settlements involve complex tax issues. Consult a qualified tax professional before finalizing any settlement or filing a return reporting settlement income.