Whether a lawsuit settlement or legal damages award is taxable depends on what the payment is compensating for - not what it is called. The controlling principle under Commissioner v. Glenshaw Glass Co. is that all recoveries are gross income unless specifically excluded. IRC §104 provides the primary exclusion: damages received on account of physical personal injuries or physical sickness are excluded from income. Everything else - emotional distress, punitive damages, lost wages, breach of contract - is taxable.
Excluded (not taxable): Damages received on account of physical personal injuries or physical sickness - including amounts for pain and suffering directly attributable to those physical injuries. Also excluded: workers compensation and certain wrongful death recoveries.
Taxable: Punitive damages (always, even if related to physical injury). Emotional distress damages not attributable to physical injury. Lost wages and back pay. Business damages (lost profits, contract breaches). Interest on any judgment.
The character of the claim determines the tax - not the label on the check.
IRC §104(a)(2) excludes "damages (other than punitive damages) received... on account of personal physical injuries or physical sickness." The word "physical" was added by Congress in 1996 specifically to exclude emotional distress recoveries from the exclusion. A settlement for emotional distress alone - without physical injury - is taxable. But if emotional distress manifests in physical symptoms (headaches, insomnia, gastrointestinal issues), the IRS has been inconsistent, and courts have split. The safest position is that emotional distress payments are taxable unless the underlying claim is for physical injury and the emotional distress is an element of damages flowing from that physical injury.
Employment discrimination settlements under Title VII, the ADEA, the ADA, and similar statutes are generally taxable as ordinary income. Back pay, front pay, compensatory damages for emotional distress, and liquidated damages are all taxable and subject to income tax withholding. Punitive damages in employment cases are taxable. The exception: amounts specifically allocated to physical injury claims arising out of the employment context (rare) may be excludable.
For discrimination and certain employment claims, attorney fees paid from the gross recovery are deductible above the line under IRC §62(a)(20). This deduction is critical because without it, the plaintiff could pay tax on the gross settlement amount while the attorney takes 33%-40% as a contingency fee - resulting in effective tax on income the plaintiff never received. The above-the-line deduction ensures the plaintiff is only taxed on the net recovery. The deduction applies to claims under federal employment discrimination statutes, whistleblower actions, and certain other listed claims.