You understand the issue. The devil is in the details and the exact facts of the case. You need to consult tax counsel for an answer to this one. My best guess is that the settlement will represent a combination of the two.
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It depends on the facts of the case and the wording of the settlement.
My comments are NOT LEGAL ADVICE. They are for informational purposes only. Actual legal advice can only be provided after you have signed an engagement letter. Answering this question does not create an attorney client relationship. Remember that without attorney client privilege you could possibly divulge information that can hurt your legal rights in the future. I am a tax attorney in Miami Florida. I can help you with your federal tax issues via a secure client portal if required.
While I will preface this response to saying I am not a tax authority and always advise my clients to consult with a tax expert before agreeing to a settlement, I can tell you from the experience of the many employment cases I have settled, the entire amount of the settlement is taxable, with the exception of legal fees which, of course, the attorney pays taxes on. Employment cases are not, typically,considered personal injuries, unless there is a bona fide physical injury caused by the employer directly related to the claims, not covered by workers compensation. This is very rare and the IRS takes a very strict position in its interpretation.
Settlement of employment cases, usually involve compensation for the loss of income, emotional damages and, sometimes, punitive damages, all of which are taxable since 1996 (when the Small Business Protection Act was signed into law). The issue that often comes into play in settlement negotiations is who pays the tax, the employer or the employee. That is where the allocation of damages is important. Many employers insist the portion allocated as wages must be paid, net, as they will deduct taxes and report it as a W-2. That portion designated as compensatory for pain and suffering or other non-wage loss is paid gross and reported via a 1099 tax form. It would be up to the employee, with advise from the tax person to decide how much, if any, of that part of the settlement is taxable. But emotional damages not resulting from a physical injury is not exempt from tax, as I understand it.
Every case is different, so there is no way to provide a blanket answer. This is a very tricky area, with serious consequences if not handled correctly, so please get proper tax advice before you make your decision on how to handle the settlement money.
They say you get what you pay for, and this response is free, so take it for what it is worth. This is my opinion based on very limited information. My opinion should not be taken as legal advice. For true advice, we would require a confidential consultation where I would ask you questions and get your complete story. This is a public forum, so remember, nothing here is confidential. Nor am I your attorney. I do not know who you are and you have not hired me to provide any legal service. To do so would require us to meet and sign written retainer agreement. My responses are intended for general information only.