This used to be one area of the tax law in which your federal tax liability depended on where you lived. However, the Supreme Court ended the confusion by holding (in Comr. v. Schleier, 515 U.S. 323 (1995)) that all amounts received in satisfaction of ADEA claims are taxable.
The Supreme Court had previously stated (in U.S. v. Burke, 504 U.S. 229 (1992)) that, to be nontaxable, an award for damages must be: (1) based on a tort or tort-like claim; and (2) must be received on account of personal injuries or sickness. The Court determined in Schleier that recoveries under the ADEA are not based on tort or tort-like injuries because the ADEA provides only for back pay and liquidated damages. Tort-like claims provide for comparatively broader relief, the Court concluded. The Court also reasoned that even though ADEA complaints are based on discrimination, recoveries under the ADEA are not awarded "on account of personal injuries" because Congress, in the Supreme Court's opinion, intended liquidated damages under the ADEA to punish the discriminating employer (which would make them taxable under the income tax laws). The IRS has also issued guidance in Rev. Rul. 96-65, 1996-2 C.B. 6, that is consistent with Schleier.
In addition, in 1996, Congress changed the law to require that amounts received after August 20, 1996, in tax years ending after that date, with some exceptions, must be received on account of personal physical injuries or physical sickness to be excludible from gross income.
Even though it appears that these changes in the law have an unfavorable impact upon claimants, there are still planning techniques available to minimize the bite that federal income taxes will take from your settlement..