Are Lawsuit Settlements Taxable Income | TheLawFirm.com

Are Lawsuits Taxable?

How does the IRS perceive income from a lawsuit settlement?

Are Lawsuit Settlements Taxable Income?

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Updated June 21, 2019
Author: Daniel Gala

When the attorneys at TheLawFirm.com settle a case, or receive a favorable verdict from a jury, our clients often ask us if the money they receive as part of the settlement or verdict counts as taxable income under IRS regulations. While the rules regarding the taxability of monetary awards and settlements—like most areas of taxation—are nuanced and somewhat complicated, the simple answer is that the IRS does not consider monetary awards stemming from personal injury claims to be taxable income, so long as the money is not compensation for medical costs or other expenses previously reported as tax deductions.

As always, please consider this general advice.

One should consult with his or her own tax attorney or CPA for advice as to the tax ramifications of a particular situation. There are exceptions to almost every legal and tax-related rule.

Furthermore, we are not and familiar with your personal finances or legal situation and therefore cannot offer specific advice. Additionally, the information provided here applies only to federal IRS guidelines in the United States. Your individual state or country likely has its own rules and regulations applicable to these situations. Therefore, if you expect to receive a monetary settlement or verdict, TheLawFirm.com recommends consulting with your own financial advisor, tax attorney or CPA before receiving the funds in order to plan appropriately for the associated tax burden, if any.

When Is A Settlement Or Judgment Taxable?

Depending on how payments are allocated within a settlement or verdict, different parts of the same monetary award may be taxed differently. The IRS typically will defer to allocations as spelled out within the settlement or verdict so long as they are “consistent with the substance of the settled claims.”

General Rules

As the IRS puts it, “To determine if settlement amounts you receive by compromise or judgment must be included in your income, you must consider the item that the settlement replaces.”

In other words, if “the item the settlement replaces” would itself be subject to taxation (for example, lost wages), then the portion of the settlement allocated to that item also is taxed. On the other hand, if “the item the settlement replaces” is not subject to taxation (i.e., medical expenses), then that portion of the settlement is not taxed.

Thus, under IRS Rules, compensation received for the following items DOES count as ordinary income for tax purposes:

  • Interest earned on any monetary award received
  • Compensation for lost wages or lost profits (in most instances)
  • Punitive damages (in most instances, even when stemming from physical injury or physical sickness)
  • Damages relating to breach of contract, patent or copyright infringement, or interference with business operations
  • Back pay
  • Damages for emotional distress related to a claim under Title VII of the Civil Rights Act of 1964

Physical Injury or Physical Illness

Applying the same principal, payments received as compensatory damages for physical injury or physical illness are not considered taxable income by the IRS. This applies whether such compensation is received in one lump sum payment or via an installment plan.

In theory at least, this is because compensatory damages, as their name suggests, are intended, to the extent possible, to compensate one for his or her physical losses through economic reimbursement. This explains why compensatory damages are not taxed as income while punitive damages, which are intended to punish to the liable party and disincentivize those who would engage in similar conduct, are.

There are, however, some instances where compensatory damages for physical injury or physical illness may be subject to income taxation. If one previously took tax write-offs for medical expenses related to the physical injury or physical illness, and one received a tax benefit for those deductions, the IRS requires that “you must include in income that portion of the settlement that is for the medical expenses you deducted in any prior year(s) to the extent the deduction(s) provided a tax benefit.”

Emotional Distress / Mental Anguish

The old adage that the answer to any legal question is, “It depends” certainly holds true in tax law, and the question of whether monetary awards related to emotional distress and/or mental anguish count as taxable income is no exception. Such payments do not count as taxable income IF they stem from underlying physical injury or illness.

“Emotional distress itself isn’t a physical injury or physical sickness, but damages you receive for emotional distress due to a physical injury or sickness are treated as received for the physical injury or sickness,” the IRS advises in its Publication 525, which lays out the rules over taxable and nontaxable forms of income. “Don’t include them in your income.”

However, in a separate publication, the IRS clarifies that “[i]f the proceeds you receive for emotional distress or mental anguish do not originate from a personal physical injury or physical sickness, you must include them in your income,” but you may deduct medical expenses related to the emotional distress or mental anguish to the extent one has not previously received a tax benefit from such expenses.

Conclusion

As the IRS suggests, when considering whether a particular allocation within a settlement or judgment is subject to income taxation, think of “the item the settlement replaces.” If that item is itself taxed, then it is likely that portion of the settlement or judgment is subject to taxation as well.

Again, exceptions apply to almost every taxation rule, and it always is advisable to speak with your own tax professional for specific advice pertaining to your particular situation

Sources:

United States Department of the Treasury Internal Revenue Service (IRS). (Rev. 12-2016). Settlements – Taxability. Publication 4345

United States Department of the Treasury Internal Revenue Service (IRS). (Last reviewed or updated 18 January 2019). Taxable and Nontaxable Income. Court awards and damages. IRS Publication 525

Legal Disclaimer: Please consider this general advice. One should consult with his or her own tax attorney or CPA for advice as to the tax ramifications of a particular situation. There are exceptions to almost every legal and tax-related rule. Furthermore, we are not familiar with your personal finances or legal situation and therefore cannot offer specific advice. Additionally, the information provided here applies only to federal IRS guidelines in the United States. Your individual state or country likely has its own rules and regulations applicable to these situations. Therefore, if you expect to receive a monetary settlement or verdict, TheLawFirm.com recommends consulting with your own financial advisor, tax attorney or CPA before receiving the funds in order to plan appropriately for the associated tax burden, if any.

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