Legacy Law Blog

Employment cases rarely settle on “gross number” damages alone anymore.

For both plaintiffs and employers, the true economics turn on how that number is allocated among wages, non‑wage compensatory damages, and any potentially excludable amounts under Section 104(a)(2).

A sloppy allocation can convert what everyone thought was a tax‑efficient deal into an IRS exam, unexpected payroll tax exposure, or a fight in U.S. Tax Court (tax court) that the parties never priced into the settlement.

By contrast, a careful, fact‑driven allocation anchored in the pleadings and record, drafted with current case law in mind, and implemented consistently in reporting can materially improve after‑tax outcomes while dramatically lowering audit risk.

This post is written with an emphasis on practical drafting and a candid look at how section 104(a)(2) and the tax court’s recent decisions shape what the Internal Revenue Service (IRS) will and will not respect with regard to employment settlement language and allocations.

Core Tax Framework for Employment Settlements

Most employment settlements start with the same core tax framework. As a baseline, Section 61 treats all amounts received as income unless a specific exclusion applies, and in the employment context, almost everything is taxable to the worker and deductible to the employer.

In practice, the IRS assumes that 70-80% of employment related settlements are not exempt from tax. Back pay, front pay, severance, liquidated damages, emotional‑distress damages and interest are all generally includible for tax purposes. Section 104(a)(2) is the narrow exception, and it is far narrower after the 1996 amendments than many practitioners remember.

Those amendments explicitly provide that “emotional distress,” and its physical symptoms (such as insomnia, headaches and stomach disorders) are not “physical injuries or physical sickness,” with only a limited carve‑out for medical‑expense reimbursements. Revenue Ruling 96‑65 underscores the point in the exact setting employment lawyers care about: back pay and emotional‑distress damages paid to settle Title VII discrimination claims are fully taxable and do not qualify for exclusion under Section 104(a)(2).

Against that backdrop, the first task in any settlement is to identify what the payment is replacing. The “origin of the claim” doctrine directs courts and the IRS to look at the underlying dispute, not the labels the parties prefer. If the main point of the case is economic loss from termination such as lost wages, lost benefits or lost promotion opportunities, then the tax law will generally treat most of the recovery as taxable wages or non‑wage income, even if the complaint or demand letter includes boilerplate language about “personal injuries.”

In Wells v. Commissioner, T.C. Memo 2009‑34, for example, the settlement agreement went out of its way to describe the payment as “damages for emotional distress due to depression and other claims, not as wages or back pay,” and it was reported on a Form 1099‑MISC, not a Form W‑2. The taxpayer attempted to exclude the payment under section 104(a)(2), but the Tax Court looked at the origin of the claim, employment retaliation causing emotional distress, and held the entire amount taxable, emphasizing that emotional distress alone does not satisfy the “physical injury or physical sickness” requirement after 1996.

The second step is to divide the settlement into conceptually distinct components and then to decide which of those categories can plausibly support any section 104(a)(2) exclusion. In a typical employment case, the principal components are wage‑type amounts (back pay, front pay, severance), non‑wage taxable damages (emotional distress, reputational harm, liquidated or punitive damages, interest) and, in a smaller subset of cases, damages for bona fide physical injuries or physical sickness.

The wage portion should be treated as such: processed through payroll, subject to income tax and FICA/FUTA withholding and reported on a Form W‑2. That treatment is consistent with IRS guidance on wage settlements and with the outcome in older back pay cases under Title VII and analogous statutes. Non‑wage components are still taxable but generally are not “wages.” They are reported on a Form 1099‑MISC to the worker (and often a 1099 to counsel as well).

For practical purposes, it helps to think in terms of a settlement as three buckets, plus attorneys’ fees.

• Wages: back pay, front pay, overtime, unpaid commissions, severance.
• Non‑wage taxable damages: non‑physical emotional distress, reputational harm, liquidated or punitive damages, pre‑ and post‑judgment interest.
• Potentially excludable 104(a)(2) damages: bona fide (tort)physical injury or physical sickness, plus related medical expenses.
• Attorneys’ fees: generally, follow the character of the underlying claims, with special above‑the‑line rules for some employment and civil‑rights matters.

Each bucket has distinct tax consequences, reporting obligations and audit sensitivities, and your settlement agreement should explicitly reflect that structure.

Section 104(a)(2) in Employment Cases

Where most of the hard questions arise, and where the recent tax court opinions are essential reading, is in the effort to carve out any portion of an employment recovery as excludable under section 104(a)(2). Courts have made clear that they will respect the statute’s “physical injuries or physical sickness” text and will not stretch it to cover garden‑variety emotional distress arising out of the workplace, even when that distress is clinically serious.

In Tillman‑Kelly v. Commissioner, T.C. Memo 2022‑111 (discussed in a 2023 Tax Adviser article), a university employee received a settlement the parties described as “non‑wage injuries, as non‑economic emotional distress damages” following termination. The taxpayer claimed an exclusion under section 104(a)(2), but the tax court held that, despite the labeling, the proceeds were fully includible in income because the underlying injury was non‑physical and the statute does not treat emotional distress as a physical injury.

Similarly, in Finnegan v. Commissioner, T.C. Memo 2021‑29, the taxpayer argued that post traumatic stress disorder and related symptoms brought the case within section 104(a)(2), but the court found that the settlement documents and record did not demonstrate that the employer paid damages “on account of” physical injury or physical sickness, and thus no exclusion was allowed.

Dern v. Commissioner, T.C. Memo 2022‑89, offers perhaps the most useful drafting lesson for employment counsel. The settlement agreement in Dern referred to “personal injuries” but did not use the statutory phrase “personal physical injuries or physical sickness,” and the taxpayer sought to exclude the proceeds under Section 104(a)(2). The tax court declined to treat the boilerplate language as determinative, looked to the underlying claims and extrinsic evidence, and concluded that the taxpayer had not proved that any part of the payment was made on account of qualifying physical injury.

For practitioners, the message is that vague references to “personal injuries” or “tort‑type harms” will not carry the day. If you intend to allocate a portion of a settlement to excludable physical injury or physical sickness, you must substantively plead, build and document that claim and then draft the agreement so that the language and allocation reflect those facts.

104(a)(2) Checklist

When you are evaluating whether any slice of an employment recovery can reasonably be allocated as excludable under section 104(a)(2), ask:

• Is there a clearly pleaded and developed claim for physical injury or physical sickness in the petition, demand letter or mediation, not just emotional distress?
• Is there contemporaneous medical documentation (diagnoses, treatment records) supporting bodily harm or physical illness in the record?
• Does the settlement agreement expressly reference “personal physical injuries or physical sickness within the meaning of section 104(a)(2)” and tie a specific amount to those claims?
• Is the 104(a)(2) portion reasonable relative to the overall claim value and defensible in light of Wells, Finnegan, Tillman‑Kelly, and Dern?
• Are client expectations set so that they understand that an aggressive 104(a)(2) allocation will likely invite scrutiny and may not hold up?

If you cannot answer those questions comfortably, you should be very cautious about allocating any part of an employment settlement as excludable 104(a)(2) damages.

Practical Allocation of Employment Damages

Once you have identified the nature of the claims and any viable 104(a)(2) component, the next step is to translate that analysis into a concrete allocation. In a typical case, you will allocate some portion of the total to wage‑type damages, including back pay, front pay, severance, which should be treated as wages, run through payroll, subjected to income and FICA/FUTA withholding, and reported on a Form W‑2.

That treatment aligns with IRS guidance on wage settlements and older Title VII back pay cases, and it avoids the trap of under‑withholding on amounts the IRS and courts clearly see as wages. Non‑wage components such as emotional‑distress damages, reputational harm, statutory liquidated or punitive damages, and interest remain fully taxable but are generally not treated as wages, so they are typically reported on Form 1099‑MISC to the plaintiff (and, where applicable, Forms 1099 to counsel).

Best practice, therefore, is to draft your settlement agreement in narrative paragraphs that spell out the nature of the claims, the relative strengths and values of each category, and the agreed allocation flowing from that analysis. The recitals should describe, in a way consistent with the complaint and discovery, the specific wage‑loss claims (e.g., alleged underpayment or termination), the non‑wage statutory or tort claims (e.g., emotional distress from discrimination or retaliation), and, if present, any claims for physical injury or physical sickness supported by medical evidence.

The operative provisions should then allocate the total settlement amount into stated dollar figures for wages (subject to withholding and Form W‑2 reporting), non‑wage compensatory damages (taxable but non‑wage, reportable on Form 1099‑MISC), and any portion that the parties agree is being paid on account of “personal physical injuries or physical sickness within the meaning of section 104(a)(2).” To have any realistic chance of being respected, that last category must be modest in relation to the overall claim, grounded in the medical record, and clearly connected in the text of the agreement to specific physical injuries or sickness, not just the emotional fallout of workplace events.

Drafting Best Practices

• Draft recitals that accurately summarize the pleaded wage, non‑wage tort or statutory, and (if present) physical‑injury or physical‑sickness claims.
• Allocate the total settlement across clearly labeled categories: wages (W‑2), non‑wage taxable damages (1099‑MISC), and any 104(a)(2) physical‑injury/physical‑sickness damages.
• Use statutory language such as “personal physical injuries or physical sickness within the meaning of section 104(a)(2)” for excludable components, not generic “personal injuries” language.
• Keep the 104(a)(2) allocation modest and grounded in the evidentiary record to avoid over‑allocations that are inconsistent with the strength of the physical‑injury claim.
• Ensure payroll and tax reporting the employer actually performs matches the agreement’s allocation. Any inconsistencies will undermine credibility in an exam or litigation.

When Defendant Refuses to Allocate Damages

When the defendant refuses to allocate, you must assume the IRS (and, if it gets that far, the tax court) will do the allocating for you based on the “origin of the claim” and the surrounding facts – not on how you wish the deal had been papered. With that in mind, your goals are to: (1) create as much contemporaneous support as possible for your client’s preferred characterization, (2) report consistently with that position, and (3) be prepared to explain and defend it in an exam.

If the defense insists on a single undifferentiated payment with no allocation among wages, non‑wage damages, and any potential section 104(a)(2) component, you can still take concrete steps to protect your client.

First, document, in your own file, the litigation‑risk analysis and how you valued each category of damages: back pay/front pay, emotional distress, other tort or statutory claims, and any physical‑injury/physical‑sickness claims. That can be a short internal memo or mediation brief that walks through the claims and the approximate dollar value you placed on each bucket. If an IRS examiner later challenges your client’s reporting, this becomes your roadmap for explaining why it was reasonable to treat a particular slice as wages, another as non‑wage compensatory damages, and (if facts support it) a limited portion as excludable under section 104(a)(2).

Second, make sure at least your side’s correspondence and mediation submissions are clear about how you are viewing the components of the settlement, even if the final agreement is silent. For example, a mediation brief or settlement letter can state that the plaintiff’s demand (or the agreed number) represents specific amounts for back pay, emotional distress, and, where appropriate, physical‑injury damages. Even if the defendant will not pick up that language in the final agreement, the contemporaneous record will show that your client’s later allocation on the tax return is not purely after‑the‑fact tax engineering.

Third, decide proactively how your client will report the settlement. If the employer issues a single Form 1099‑MISC for the entire payment, you still have to choose how much of that to report as wage‑equivalent income, for example back pay, and how much as other income, bearing in mind that the IRS will expect back‑pay‑type amounts to be treated like wages even if the defendant refused to withhold.

You should counsel the client that the safest course is usually to treat amounts that clearly substitute for wages as taxable earned income and then consider whether any portion can reasonably be treated as non‑wage damages or excluded under section 104(a)(2). Being conservative on the wage side often reduces the exam risk enough that you can defend a modest, well‑supported non‑wage or 104(a)(2) allocation.

Finally, if you have a solid physical‑injury/physical‑sickness component but cannot get the employer to say so, consider whether you can attach a detailed explanatory statement to the return describing the claim, the medical evidence, and your allocation methodology. That transparency can help at the audit stage, even when the settlement agreement itself is unhelpfully generic.

Avoiding and Responding to an IRS Audit

The best audit defense is built at the drafting stage. Allocations that try to push most or all of an employment settlement into non‑wage or non‑taxable categories, when the real dispute was about pay and emotional distress, will look like red flags to examiners familiar with Wells, Finnegan, Tillman‑Kelly, and Dern.

You can reduce that risk by aligning your allocation with the origin of the claims, treating wage components as wages with proper withholding, and using 104(a)(2) only where the record genuinely supports physical‑injury or physical‑sickness damages.

The same discipline that improves the quality of the drafting also pays dividends in audit defense. IRS guidance and its internal training materials direct examiners to evaluate the nature of the underlying claim, the agreement’s characterization, and the consistency of the parties’ reporting, all through the lens of section 104(a)(2) and cases like Wells, Tillman‑Kelly, Finnegan and Dern. If your file shows that you evaluated the claims along these lines at the time of settlement, that the allocation was negotiated at arm’s length between adverse parties, and that payroll and information reporting followed the agreed allocation, you will be far better positioned to resolve an exam at the agent or appeals level.

By contrast, if the record reflects that the parties first agreed to a gross number and then tried to retrofit an aggressive 104(a)(2) allocation for tax reasons after the fact, you are squarely in the pattern that produced unfavorable results in the recent tax court opinions and that will invite IRS skepticism.

In short, it is best to treat tax characterization and Section 104(a)(2) not as boilerplate allocations at the back of the settlement agreement but as strategic issues integrated into case assessment, negotiation and drafting from the outset. Doing so requires fluency with the statute and regulations, careful reading of modern tax court decisions, and close coordination with tax counsel and payroll teams to make sure the allocations are correct and will hold up if challenged.

The payoff for doing so will lead to more predictable after‑tax outcomes for clients, fewer unpleasant surprises at audit and settlement agreements that stand up when an IRS examiner or judge reads them cold.

A Neutral Opinion May Help

Employment related settlements can become complex and contentious fast. The opinion of a neutral tax professional can assist with reviewing and drafting settlement language as well as counseling clients bent on maximizing 104(a)(2) allocations to reduce personal income tax liability.

Understanding how to carefully crafted employment settlement language can lead to advantageous income tax allocations and decrease your client’s changes of running amok with the IRS.