Tax Consequences of a Legal Settlement

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Have you been awarded money or property as a result of a lawsuit or legal settlement? There may be some tax issues you need to know about. It depends on your case and why you received payment.

Taxes on Personal Injury Awards

Personal physical injury or physical sickness awards aren't included in income. The money you receive isn't taxed. It doesn't matter if you're paid with a lump sum or installments. However, you'll pay tax on punitive damages from a personal injury lawsuit.

Non-Personal Injury Lawsuits

Awards received in non-personal injury lawsuits are generally taxable as ordinary income. The following items count as ordinary income and are taxable:

  • Interest on any award
  • Most payments for lost wages or lost profits
  • Most punitive damages (regardless if physical injury or illness is involved)
  • Amounts received in settlement of pension rights (if you didn't pay into the plan)
  • Damages for patent or copyright infringement, breach of contract or interference with business operations
  • Back pay and damages for emotional distress for claims in Title VII cases
  • Attorney fees and costs (including contingent fees) where the underlying recovery is included in gross income

You may be asking why attorney fees and costs would be taxed. What this refers to is when a person is awarded attorneys fees and costs as the winning party in a lawsuit. The award amount is included in gross income. In turn, you may be able to claim a business expense deduction for these fees and costs.

Damages for Emotional Distress

Tax treatment of awards compensating for emotional distress depends on the case. Emotional distress itself isn't a physical injury or physical sickness. However, damages you receive for emotional distress for such an injury or sickness are treated as received for the physical injury or sickness. The result is that these damages aren't income and aren't taxable.

Damages count as income if the emotional distress didn't arise from physical injury or sickness. An example is employment discrimination or injury to reputation. There's an exception for any damages you receive when emotional distress leads you to seek medical treatment. Emotional distress may lead to physical symptoms, such as headaches, insomnia and stomach disorders.

Questions for Your Attorney

  • Regarding taxes, is an award paid by lump sum or installment better?
  • I didn't know I had to pay taxes on a settlement award from several years ago. What should I do?
  • Can my award be paid to someone else in a lower tax bracket, such as a relative?
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