Are Emotional Distress Damages in FEHA Settlements Taxable?
In California FEHA settlements, plaintiffs often recover damages for both emotional distress and lost wages—but how are those payments taxed? Employers often compel an allocation in damages between wages (economic loss) and emotional distress. In California FEHA (Fair Employment and Housing Act) litigation settlements, the tax treatment of emotional distress damages depends on whether they're related to physical injury or physical sickness.
How the IRS Treats Emotional Distress Damages
Understanding how the IRS differentiates emotional distress damages is essential in employment-related settlements. The key distinction hinges on whether the distress stems from physical injury or sickness—this determines whether it's taxable.
- If the emotional distress is not attributable to physical injury or physical sickness, the damages are typically taxable income and would be reported on Form 1099-MISC (in Box 3, "Other Income").
- If the emotional distress is attributable to physical injury or physical sickness, those damages are generally not taxable and wouldn't require a 1099.

What This Means for FEHA Cases
FEHA cases frequently involve claims of emotional distress arising from discrimination or harassment, but these claims usually do not involve physical injury. As a result, even large settlements under FEHA may have significant tax consequences for plaintiffs.
Take, for example, a common settlement scenario: a plaintiff settles a FEHA case for $200,000, with $80,000 allocated to back pay and $120,000 to emotional distress. Because the emotional distress wasn't caused by a physical injury, the entire $120,000 is taxable. This outcome underscores the importance of how damages are categorized and the need for precise structuring in the settlement agreement.
- Most emotional distress damages in these cases are considered nonphysical and therefore taxable.
- The defendant/payor would typically issue a 1099-MISC for the emotional distress portion.
- Lost wages/income portions are also taxable (usually reported in Box 1 of Form W-2 or on 1099-MISC).
Practical Guidance for Attorneys and Neutrals
Settlement agreements often allocate amounts between different types of damages.
- How the settlement is structured and documented can affect tax treatment.
- Physical symptoms of emotional distress (insomnia, headaches, humiliation) typically don't qualify as "physical injury" for tax exemption purposes under current IRS interpretation.
Since tax implications can be significant and complex, plaintiffs should consult with a tax professional or attorney before finalizing any settlement to understand the specific tax consequences and reporting requirements for their situation.
State Versus Federal Tax Rules
California tort law tends to treat emotional and physical injuries similarly, especially when emotional harm results in physical symptoms. However, for tax purposes, federal law controls. This distinction is crucial.
Even if California law recognizes severe emotional distress as warranting substantial damages, the IRS may still classify that same distress as taxable income. Thus, the state-federal divide can complicate expectations around tax obligations.
Bottom Line for Legal Practitioners
Attorneys should advise clients early about the potential federal tax treatment of emotional distress damages. The IRS follows the U.S. Supreme Court's decision in Commissioner v. Schleier (515 U.S. 323 (1995)) and subsequent guidance, which interprets Internal Revenue Code § 104(a)(2) narrowly. Under federal tax law:
- Only damages for "personal physical injuries or physical sickness" are excludable from income.
- The IRS has consistently held that emotional distress, even with physical symptoms, is not a "physical injury" unless it originates from a physical injury.
- This federal interpretation controls regardless of how California law characterizes emotional distress.
So, even though California law may treat emotional distress as akin to physical injury for purposes of tort damages or workers' compensation, the IRS doesn't recognize this characterization for federal income tax purposes.
This creates the unfortunate situation where California plaintiffs may recover substantial emotional distress damages under state law theories (like FEHA) but still owe federal taxes on those damages because the IRS applies its own, narrower definition of "physical injury." Practitioners take notice.
Disclaimer: This content is intended for general informational purposes only and should not be construed as legal advice. If you require legal or professional advice, please contact an attorney.
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