Taxation of Lawsuit Settlements: What You Need to Know

When it comes to taxation of lawsuit settlements, the Internal Revenue Service (IRS) states that “all income from any source derived” is taxable, except for personal injury and physical injury settlements. This means that almost every penny earned in a settlement is taxable, unless there is a specific exception. The IRS excludes some income from lawsuits, settlements and tax awards, but not all. It is important to understand the different types of settlements and how they are taxed. Agreements and judgments are treated the same way for tax purposes.

A judgment refers to a formal judicial resolution of a dispute, in which the court may order one of the parties to pay pecuniary compensation to another. An agreement refers to a mutual agreement between litigants. Depending on the circumstances, compensation for loss of wages, unfair dismissal, or dismissal may be taxable as income. The biggest exception to the rule that all income is taxable comes into play with personal injury compensation agreements. If you get a settlement on a lawsuit that arises from an injury that occurred in an accident, part or all of the compensation may arise from various types of emotional distress or punitive damages awarded by the court due to the defendant's heinous conduct.

In this case, the IRS excludes the income from taxation. In certain business disputes, however, the IRS taxes a loss of profits settlement as ordinary income. If you win compensation for damage to your home caused by a negligent builder, rather than taxable income, the IRS can treat that compensation as a reduction in the purchase price of the property. If you sue after suffering a physical injury, such as in a car accident or other type of personal injury, the IRS believes that the compensation you would receive after reaching a settlement is not taxable. This does not include punitive damages, which are taxed by the federal government. However, if you deducted any of your medical expenses in previous years, you must report the settlement funds as income because you cannot use the same tax exemption twice. Emotional distress is different from non-visible injuries, but it is managed in a way.

Recoveries for physical injuries and physical illnesses are tax-free, but symptoms of emotional distress are not physical. This area of law becomes very complicated. Did physical injury cause emotional distress or did emotional distress cause physical symptoms? In a nutshell, if the defendant caused your physical injury, it's a tax-free event, but if emotional distress made you physically ill, you're likely taxable. Prior to 1996, personal injury was not taxed. Therefore, claims agreements such as emotional distress and defamation were tax-free.

However, since 1996, only the money from the physical injury settlement is not taxable. Compensation for emotional distress is not taxed only if it originated from a personal physical injury or physical illness. Courts have distinguished between signs of emotional distress and symptoms of emotional distress. A symptom is “subjective evidence of illness” of a patient's condition. Emotional distress can involve physical symptoms such as stomach pain, headaches and stomach disorders but they are not generally considered physical injuries or physical illnesses. In some circumstances, a court may award punitive damages as a form of punishment for those responsible for the lawsuit.

Punitive damages are generally taxable; however it depends on the state. For example, personal injury claim settlements including punitive damages are not taxable under Pennsylvania personal income tax law. Attorneys' fees are another complex area related to settlement taxation. If your lawyer represents you in a personal injury lawsuit on a contingency fee basis, you can pay tax on 100 percent of the money recovered by you and your lawyer even if the defendant pays the contingency fee directly to their personal injury lawyer. If your settlement is not taxable such as a settlement resulting from injuries sustained in a car accident you shouldn't face any tax hardship. The U.

S Supreme Court ruled that a plaintiff's taxable income is generally equal to 100 percent of their settlement even if your lawyers take part. In addition in some cases you cannot deduct legal fees from your tax base. The tax language used in a settlement agreement is not binding on the IRS or courts in subsequent tax disputes but should be as specific as possible about taxes. When parties agree on tax treatment although it is not binding the IRS takes into account their intention.