Before 1996, there was an argument, weakened by United States v. Burke, 504 U.S. 229 (1992), that settlements (and jury awards) in employment discrimination claims were not taxable. Burke held that a back pay award under the pre-1991 version of Title VII of the 1964 Civil Rights Act was not excluded from income but rested its conclusion on the type of damages that could be awarded in a Title VII suit (at that time). The decision caused more confusion than it resolved leading to later Court decisions and, ultimately, led Congress to close the discrimination "loophole" in 1996. Now, to be excluded from gross income, the settlement must be for personal physical injuries or physical sickness, emphasizing the "new" (as of 1996) changes. That exclusion (from income) effectively includes most every amount paid to settle a discrimination or retaliation claim. The IRS is now getting around to eliminating language from its regulation that was obsolete in 1996.
Most employers probably don't care whether the amount paid to an employee is taxable income to the employee. Be assured that employees do. Virtually every time I settle a discrimination or retaliation claim, the other lawyer asks me whether the settlement amount is taxable. Most have caught on that it is but they just want to make sure they haven't missed any recent change on this front.
They have good reason to ask, I suppose. Every Congress since 2001, has had introduced a bill that would permit parts of a discrimination settlement to be excluded from income. H.R. 3035 is the current iteration. It would exclude emotional distress damages in discrimination but would still tax back pay and punitive damages. It would permit employees to average the back pay damages over the period covered by the lawsuit or settlement.
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