Tax Consequences of a Legal Settlement

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.

Taxes on Personal Injury Awards

If you sue someone for causing you personal physical injury or physical sickness, any damages or settlement you receive to compensate you for your medical expenses, lost wages, and pain, suffering, and emotional distress is not included in income. The money you receive isn't taxed. It doesn't matter if you're paid with a lump sum or in installments.

However, an award of punitive damages from a personal injury lawsuit is taxable. Punitive damages aren’t intended to compensate you for your loss. Rather, they are awarded to punish and make an example of the wrongdoer. In some states punitive damages awarded in a wrongful death case are not taxable.

Non-Personal Injury Lawsuits

If you sue someone for a claim not involving personal injury—for example, a discrimination suit or a suit to collect back pay—any award or settlement you receive is generally taxable as ordinary income. This means you’ll pay tax on the amount at your personal income tax rate.

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 (these are discrimination claims against employers).

Often, attorneys who represent plaintiffs are paid on a contingency basis—that is, they get a percentage of any damages or settlement that they obtain for their client. The contingent fee is deducted from the award and given to the attorney. Does this mean you need not pay tax on the amount of the contingency fee? Unfortunately, the answer is no. You must pay tax on the entire award you receive, including the amount taken out and paid to your attorney. Similarly, if the losing side is ordered by the court to pay your attorney fees and costs, the amount must be included in your taxable income.

It’s no fun having to pay taxes on a damages award or settlement. But whenever your damages are taxable you are allowed to deduct your attorney fees. This can be a business deduction if the lawsuit was related to your business. If not, it would be a personal miscellaneous itemized deduction. However, you are allowed to deduct attorney fees for certain discrimination cases directly from your gross income.

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 caused by physical injury or sickness are tax free. For example, damages for emotional distress arising from physical injuries received in a car accident are tax free.

On the other hand, damages for emotional distress that didn’t arise from physical injury or sickness are taxable income. For example, damages for emotional distress arising from an employment discrimination claim are taxable. But there is a limited exception when emotional distress leads you to seek medical treatment for physical symptoms, such as headaches, insomnia, and stomach disorders. In this event, emotional distress damages up to the amount of your actual medical care expenses are tax free.

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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