Have Tax Questions? Ask a Tax Expert for Answers ASAP
Hi and welcome to Just Answer!In general - such payments are classified as a foreign annuity and are taxable in the US.According to the US-Germany tax treaty - payments are taxed only in the state of residency.See for reference - http://www.irs.gov/pub/irs-trty/germany.pdf page 25 - ARTICLE 18 Pensions, Annuities, Alimony, and Child Support
2. Subject to the provisions of Article 19 (Government Service; Social Security), annuities derived and beneficially owned by a resident of a Contracting State shall be taxable only in that State. The term "annuities" as used in this paragraph means a stated sum paid periodically at stated times during a specified number of years, under an obligation to make the payment in return for adequate and full consideration (other than services rendered).
For the purposes of this Convention, the term "resident of a Contracting State" means any person who, under the laws of that State, is liable to tax therein by reason of his domicile, residence, place of management, place of incorporation, or any other criterion of a similar nature.
Where an individual is a resident of both Contracting States, then he shall be deemed to be a resident of the State in which he has a permanent home available to him; if he has a permanent home available to him in both States, he shall be deemed to be a resident of the State with which his personal and economic relations are closer (center of vital interests).Thus if the US citizen is a resident of Germany - such payments are not taxable in the US - and may only be taxed or not in Germany based on local laws.If however - he/she is a resident of the US - payments are included into taxable income as foreign annuity. If there are any income tax liability depends on many items - total income, filing status, deductions, etc.
It might be possible to treat such payments as compensatory damages for personal injury. However - there is no established practice and it is not clear if the IRS accepts such classification.