The taxability of any settlement or judgment depends on what the payment is intended to replace; its character mirrors the nature of the underlying claim. Items treated as ordinary income generally include:
Interest paid on an award or settlement.
Payments for lost wages or lost business income, in most situations.
Punitive damages, even when connected to a physical injury or physical illness claim.
Settlement amounts for pension rights when the taxpayer did not pay into the plan.
Damages relating to business or contract matters, such as:
Patent or copyright violations,
Breach of contract claims,
Disruption or interference with business activities.
Back pay and emotional-distress damages tied to claims under Title VII of the Civil Rights Act of 1964. Back pay is taxable; emotional-distress damages are taxable unless they are directly related to physical injury.
Attorney fees and litigation costs (including contingent fees) when the associated recovery must be included in gross income.
Attorney fees are connected to whistleblower awards when the underlying award is taxable.
NOTE: Payments intended to compensate for personal physical injuries or physical illness, whether they are paid all at once or over a longer time, are not included in income.