Jeffrey Easley and his firm have negotiated hundreds of employment separation agreements for employees - involving millions of dollars in severance pay, stock, and benefits. Severance negotiations focus on obtaining the best possible bargain for our clients. Issues include an amicable separation, terms of separation, severance pay, stock (if issued/available), benefits including COBRA coverage, non-disparagement, confidentiality, employment references, unemployment insurance, tax issues regarding severance pay and stock, and more.


Per the American Bar Association:


As a general rule, nearly all settlement payments in an employment lawsuit are included in the plaintiff’s taxable income.  This includes payments for back wages, front pay, emotional distress damages, interest awards, and punitive/liquidated damages.  The only exceptions to this general rule are: (1) certain payments for attorneys’ fees (which are discussed below in Guideline #2); and (2) payments intended to compensate the plaintiff for damages “on account of personal physical injuries or physical sickness.”  I.R.C. § 104(a)(2) (emphasis added).  In addition, payments for mental anguish are not taxable if they do not exceed the actual medical expenses attributable to the emotional distress.  I.R.C. §§ 61, 104(a)(2).


To exclude a settlement recovery (or any portion thereof) from taxation under section 104(a)(2)’s “physical injury/sickness” exception, the taxpayer must show that the settlement payment was received “on account of personal physical injuries or physical sickness.”  Id. (emphasis added).  The key to excluding settlement proceeds from gross income under section 104(a)(2) is establishing that the taxpayer suffered observable or documented bodily harm, such as bruising, cuts, swelling or bleeding.  See IRS Counsel Memorandum, Income and Employment Tax Consequences and Proper Reporting of Employment-Related Judgments and Settlements (Oct. 22, 2008).  If the plaintiff did not suffer these types of observable physical injuries as a result of the conduct in question, she is not eligible to exclude any portion of the settlement proceeds under section 104(a)(2).  However, if the plaintiff did suffer these types of observable physical injuries, the plaintiff may exclude any settlement proceeds intended to compensate her for these injuries, and for other damages caused by these injuries.  For example, if the plaintiff was sexually assaulted by a supervisor and asserts a hostile work environment claim, the plaintiff may exclude any settlement amounts paid as compensation for: (1) the physical injuries suffered in the assault, (2) emotional distress arising out of the plaintiff’s physical injuries, and (3) wages lost because of the plaintiff’s physical injuries.  However, settlement payments for physical symptoms that result solely from emotional distress unrelated to any observable physical injuries are not excludable under section 104(a)(2).  See I.R.C. § 104(a)(2); H.R. Rep. No. 104-737, at 301 n. 56 (1996) (Conf. Rep.)., 1996-3 C.B. 741, 1041.


Most employment-related disputes do not involve physical injuries, such as bruising, cuts, swelling, or bleeding.  Instead, the injuries typical in employment cases (such as insomnia, headaches, weight loss, stomach disorders, etc.) are related to the emotional distress allegedly caused by being discriminated against, or by being subjected to a hostile work environment.  Settlement payments to compensate for these types of “soft” injuries are not “on account of a” physical injury or physical sickness, and are, therefore, not excludable from the plaintiff’s gross income under section 104(a)(2).  Id.  Thus, absent a claim involving a battery, settlements for injuries in an employment case will generally be included in the plaintiff’s gross income.

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