When individuals or businesses are involved in legal disputes that result in settlements or judgments in their favor, one common question arises. Do you pay taxes on lawsuit settlements? The answer to this question can vary depending on the nature of the lawsuit, the type of damages awarded, and specific circumstances surrounding the case. Let’s look into the tax implications associated with lawsuit settlements.
Taxability of Lawsuit Settlements
Internal Revenue Code (IRC) Section 61 broadly defines gross income as all income from whatever source, unless specifically excluded by another provision of the tax code. In addition, IRC Section 104 provides an exclusion from gross income for certain types of compensation received in legal settlements or judgments. In other words, you don’t have to count certain types of money you receive from legal settlements or insurance if they’re related to personal physical injuries or sickness. However, the exact circumstances surrounding the case will help determine the taxability of settlements and judgements. Let’s look at different types of lawsuit settlements.
Compensatory Damages vs. Punitive Damages
Compensatory damages are intended to compensate the plaintiff for losses suffered. This typically includes damages for physical injuries, emotional distress, lost wages, medical expenses, and property damage. Compensatory damages are usually not taxable. They are meant to restore the individual to the position they were in before the injury or loss occurred. Punitive damages, on the other hand, are awarded to punish the defendant for particularly egregious behavior and to deter others from engaging in similar conduct. In many cases, punitive damages are taxable as ordinary income.
Physical Injury or Sickness
If a lawsuit settlement is related to physical injury or sickness, the compensatory damages received are generally not taxable. This includes damages for medical expenses, pain and suffering, and loss of consortium. Again, if a portion of the settlement is allocated to punitive damages or other non-compensatory damages, that portion may be taxable.
Emotional Distress
Emotional distress damages are a bit trickier when it comes to taxation. Typically, damages awarded for emotional distress are taxable, even if there were physical symptoms as well. Section 104 does not consider headaches, insomnia, or stomach conditions as qualified physical symptoms. However, if you experienced a physical injury or sickness, damages might be tax-free.
Lost Wages and Lost Profits
Compensation for lost wages and lost profits is typically taxable as ordinary income. This includes settlements related to employment discrimination, wrongful termination, retaliation, or lost business income. This is because you are typically not suing because of physical injury. Keep in mind that not only will income taxes be due in this type of settlement, but also other wage-related taxes as well, including FICA taxes.
Attorney’s Fees
Attorney’s fees paid from a settlement may or may not be deductible, depending on the specifics of the case and applicable tax laws. In general, cases dealing with employment discrimination, retaliation, or whistleblower claims can deduct legal fees “above the line.” An “above-the-line” deduction is one you can claim on your tax return before calculating your adjusted gross income (AGI). As of the passing of the 2017 Tax Cuts and Jobs Act, you cannot deduct legal fees for most other cases. In addition, the Act also requires individuals to pay tax on the total gross settlement. This includes money paid to your attorney. For example, if your settlement was $20,000 and the attorney’s received $5,000, you’d pay tax on the entire $20,000 settlement and not just on your $15,000 cut. The attorney also pays their own share of tax on their cut.
Reporting Lawsuit Settlements on Tax Returns
When it comes to reporting lawsuit settlements on tax returns, it’s essential to accurately categorize the income and follow the IRS guidelines. If you receive settlement income, you’ll typically receive IRS Form 1099-MISC. This form is used to report miscellaneous income, including settlements. Keep in mind, however, that you won’t receive this form if your settlement income is not taxable. There may be a few exceptions to which form you’ll receive. For example, if you receive back pay from your employer, these proceeds would be reported on your W-2 Form. In addition, if you received settlement interest, you should receive IRS Form 1099-INT.
Remember, even if you don’t receive a Form 1099, you are still responsible for reporting taxable income from lawsuit settlements on your tax return. Keep detailed records of the settlement, including any documentation related to the lawsuit, legal fees, and the allocation of damages.
Tax Help for Those Who Won a Lawsuit Settlement
Navigating the tax implications of lawsuit settlements can be complex. You should consult with a tax professional or attorney for guidance tailored to your specific situation. Understanding the distinction between compensatory and punitive damages, and the tax treatment of different types of settlements, is crucial for accurately reporting income and avoiding potential tax issues in the future. By staying informed and seeking expert advice when needed, individuals and businesses can effectively manage the tax consequences of legal settlements. Optima Tax Relief is the nation’s leading tax resolution firm with over a decade of experience helping taxpayers with tough tax situations.
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