The Internal Revenue Service (IRS) is very clear on the taxability of proceeds received from a lawsuit settlement. Generally, proceeds received from settlements involving damage to economic interests or property must be reported as income to the taxpayer. Receiving a lump sum payment in exchange for the promise not to sue based on age discrimination classifies as a settlement. According to the IRS, any funds received from a settlement are taxable and must be included as gross income.
Assume Mary entered into a settlement agreement and received $10,000, but she also hired a lawyer to negotiate the terms of the settlement and this lawyer charged Mary $2000. After deducting the lawyer's cost, Mary only received $8,000. However, the IRS requires Mary to include the full $10,000 in her income. However, Mary can deduct the $2000 cost of legal representation on Schedule A of her tax return as a miscellaneous itemized deduction.
There are certain types of settlements that can be excluded from gross income. If a taxpayer settles a claim involving a physical injury or sickness, the proceeds from those types of settlements are usually non-taxable. Other settlements may also be subject to regular withholding. A settlement that might be subject to withholding whether or not you continue to work for the employer might be one that is classified as "back pay."