The answer depends heavily on the classification of the award. The tax consequences vary based on whether the damages cover lost wages, pain and suffering or a physical injury.
In general, if you win a lawsuit or negotiate a settlement the amount you receive is taxable according to the definition of gross income. As with many things in the tax code, there is an exception to the general rule. Damages tied to “personal physical injuries of physical sickness” are excluded from income. The Internal Revenue Service views this exception narrowly.
Emotional distress along with its physical symptoms and depression and anxiety do not fit within the category of physical sickness or injury. This issue came up in a recent Tax Court opinion.
An employee needed an accommodation at work related to treatment for an illness. The employer worked with him, but soon backtracked and eventually fired the employee. The employee filed a disability discrimination lawsuit and settled with his former employer for $35,000.
The settlement covered $5,000 of lost wages and the rest was described as related to “pain and suffering and emotional distress.” The taxpayer included the $5,000 of lost wages (this amount appeared on his W-2) as income, but excluded the $30,000 believing “paining and suffering” was the same as physical injury or sickness.
In a tax audit, the IRS claimed the amount should have been included as income because it related to the depression and anxiety suffered by the taxpayer after his employer fired him. The Tax Court agreed with the IRS after looking at the claims alleged by the taxpayer (i.e. that he suffered “severe emotional distress, anxiety and depression”) in the employment lawsuit. The full amount of settlement turned out to be taxable.
An express statement in the settlement describing an award as for physical injuries or physical sickness may be one way to avoid negative tax consequences.
Source: Forbes, “Tax Court: Anxiety, Depression Are Not Physical Injuries,” Tony Nitti, Sept. 22, 2014