Are Employment Settlements Taxable in California? (Harassment, Discrimination & Wrongful Termination)

Short answer: most of it, yes. In California, the part of a sexual harassment, discrimination, or wrongful termination settlement that replaces lost wages is taxed as wages. The part paid for emotional distress is taxable income unless it comes from a physical injury. Punitive damages and interest are always taxable. There is one rule that works in your favor: in a harassment, discrimination, or retaliation case, the share that goes to your attorney is deductible “above the line,” so in most cases you are not taxed on money you never kept.

Key Takeaways

• Back pay, front pay, and severance are wages. Income tax, Social Security, and Medicare are withheld, and they are reported on a Form W-2.
• Emotional distress damages are taxable unless they flow from a physical injury or physical sickness. Money that reimburses therapy and other medical costs for that distress is not taxed, as long as you did not already deduct those costs.
• Punitive damages and interest are taxable in every case.
• Attorney’s fees count as your income, but you can deduct them above the line in unlawful discrimination cases, a category that includes FEHA harassment and retaliation claims. California follows the same rule.
• The settlement agreement’s allocation matters. The IRS generally accepts the split between wages, emotional distress, and fees if it matches the claims you actually settled.

How Each Part of an Employment Settlement Is Taxed

An employment settlement is rarely a single payment. The agreement usually divides the money into categories, and each category follows its own tax rule:

The IRS explains these rules in Publication 4345, Settlements — Taxability, and in its guidance on the tax implications of settlements and judgments.

Is a Sexual Harassment Settlement Taxable?

In most cases, yes. Most of a typical sexual harassment settlement compensates emotional distress, and the tax code taxes emotional distress damages unless they are paid “on account of personal physical injuries or physical sickness” (26 U.S.C. § 104(a)(2)). The same section says plainly that emotional distress is not itself a physical injury. Physical symptoms of distress, such as insomnia, headaches, or stomach problems, are generally treated as part of the emotional distress rather than as a physical injury.

The picture can change when the harassment included physical contact that caused physical injury, such as a sexual assault. Damages paid on account of that physical injury, and emotional distress that flows from it, can be excluded from income. Whether a given payment qualifies depends on the facts and on how the settlement agreement describes it, so this needs to be addressed while the agreement is being drafted, not after it is signed.

What about a confidentiality clause? Since 2018, an employer cannot deduct a sexual harassment settlement, or the related attorney’s fees, if the settlement is subject to a nondisclosure agreement (26 U.S.C. § 162(q)). That rule affects the employer, not you. The IRS has confirmed that recipients of these settlements are not precluded from deducting their attorney’s fees because of an NDA. California law also limits what a harassment NDA can hide; see our guide to NDAs in California sexual harassment settlements.

Is Emotional Distress Settlement Money Taxable?

Yes, unless the emotional distress comes from a physical injury or physical sickness. Two points reduce the bite:

• Medical costs for the distress are not taxed. Under the language that follows § 104(a)(5), damages up to the amount you paid for medical care attributable to emotional distress (therapy, counseling, psychiatric care, medication) are excluded, provided you did not already deduct those costs. Keep the receipts.
• No payroll taxes. The IRS notes that damages for non-physical injury such as emotional distress and humiliation, “although generally includable in gross income, are not subject to Federal employment taxes.” You owe income tax on them, but not Social Security or Medicare.

Are Discrimination and Wrongful Termination Settlements Taxable?

Yes. In a discrimination, pregnancy discrimination, retaliation, or wrongful termination case, the part of the settlement that replaces lost pay (back pay, front pay, severance) is wages. IRS Publication 4345 states that this portion is “taxable wages and subject to the social security wage base and social security and Medicare tax rates,” with withholding by the payer. Expect it on a W-2 with taxes already taken out. Any emotional distress and punitive portions follow the rules above.

Because the wage portion is taxed differently from the rest, the split in the agreement directly changes what you take home. For what these cases typically resolve for, see our guides to wrongful termination settlements in California and pregnancy discrimination settlement amounts.

Do You Pay Tax on the Part That Goes to Your Lawyer?

The starting rule is harsh. In Commissioner v. Banks, 543 U.S. 426 (2005), the U.S. Supreme Court held that when a recovery is income, the plaintiff’s income includes the part paid to the attorney as a contingency fee.

Congress fixed that problem for most employment cases. 26 U.S.C. § 62(a)(20) allows an above-the-line deduction for attorney’s fees and court costs in any action involving a claim of “unlawful discrimination,” which § 62(e) defines broadly enough to cover Title VII and state laws, including FEHA, that prohibit discrimination, harassment, or retaliation in employment. The deduction cannot exceed the income you received from the case.

California follows the same rule. According to the Franchise Tax Board, “California conforms to the federal above-the-line deduction for attorney’s fees and court costs incurred in connection with an unlawful discrimination claim” (FTB analysis).

A simple example: a $300,000 harassment settlement with a 40% contingency fee. You report the full $300,000 as income, then deduct the $120,000 fee above the line, so you are taxed on roughly $180,000, the amount you actually received. The wage portion is taxed as wages and the rest as other income.

Does California Tax Employment Settlements Too?

Yes. California’s income tax generally follows the federal rules on which parts of a settlement are taxable, and it conforms to the attorney’s-fee deduction described above. State income tax is withheld from the wage portion. There is no separate California tax on the settlement itself.

How to Keep More of Your Settlement, Legally

• Get the allocation right in the agreement. Per IRS Publication 4345, the IRS “generally… will not disturb an allocation if it is consistent with the substance of the settled claims.” An allocation that matches your real damages is worth negotiating. An allocation invented only to avoid tax is not.
• Document medical and therapy costs tied to the emotional distress. They reduce the taxable part of that portion.
• Claim the attorney’s-fee deduction on both your federal and California returns.
• Plan for the bill. Taxes are usually not withheld from the non-wage portion. The IRS notes you may need to make estimated tax payments if you expect to owe $1,000 or more.
• Ask about timing. For a large settlement, splitting payments across two tax years can sometimes lower the total tax. Whether it helps depends on your other income.
• Talk to a CPA before you sign, not after the 1099 arrives.

This page explains general rules. It is not tax advice for your situation. Every settlement is different, and a tax professional should review yours.

Frequently Asked Questions

Do I have to pay taxes on a sexual harassment settlement?

Usually, yes. The emotional distress portion is taxable income unless it stems from a physical injury, lost-wage portions are taxed as wages, and punitive damages are always taxable. If the harassment caused physical injury, the part paid on account of that injury can be tax-free. The attorney’s-fee portion is deductible above the line, so in most cases you are taxed only on what you actually received.

Is emotional distress settlement money taxable in California?

Yes, for both federal and California income tax, unless the distress comes from a physical injury or physical sickness. Amounts that reimburse medical care for the distress, such as therapy and medication, are excluded if you did not deduct those costs before. Emotional distress damages are not subject to Social Security or Medicare taxes.

Are back pay and lost wages in a settlement taxed?

Yes. Back pay, front pay, and severance in an employment settlement are wages. The employer withholds income tax, Social Security, and Medicare and reports them on a Form W-2, as IRS Publication 4345 explains.

Is a pregnancy discrimination settlement taxable?

Yes, under the same rules as other discrimination settlements: lost wages are taxed as wages, emotional distress and punitive damages are taxable income, and the attorney’s fees are deductible above the line because pregnancy discrimination is unlawful discrimination under FEHA and federal law.

Can I deduct attorney’s fees from a harassment or discrimination settlement?

Yes. Under 26 U.S.C. section 62(a)(20), attorney’s fees and court costs in a case involving unlawful discrimination, which includes harassment and retaliation claims under FEHA and Title VII, are deductible above the line, up to the income you received from the case. California conforms to this deduction, and an NDA in a sexual harassment settlement does not take it away.

Will I get a W-2 or a 1099 for my settlement?

Often both. The wage portion is reported on a Form W-2 with taxes withheld. Emotional distress, punitive damages, and other non-wage amounts are reported on a Form 1099, and the attorney’s-fee portion is also reported on information returns.

Are punitive damages taxable?

Yes. Punitive damages are taxable in every case, even in a settlement for physical injuries. They are reported as other income.

Sources

• IRS, Publication 4345, Settlements — Taxability (Rev. 9-2023)
• IRS, Tax Implications of Settlements and Judgments
• 26 U.S.C. § 104 and § 62(a)(20), (e)
• IRS, Section 162(q) FAQ
• California Franchise Tax Board, Bill Analysis, SB 1377 (federal/state law discussion of the discrimination-fee deduction)
• Commissioner v. Banks, 543 U.S. 426 (2005)

Related: sexual harassment settlement amounts in California · Los Angeles sexual harassment attorney · Los Angeles pregnancy discrimination lawyer