Settlement money and damages collected in a lawsuit are considered income, which means that the IRS will generally tax that money. In terms of terminology, 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. The agreement refers to a mutual agreement between litigants. Agreements are a different process than adjudication by a court, binding arbitration, or other types of formal hearings.
However, for tax purposes, judgments and settlements are treated the same way. The general rule of taxation for amounts received from resolution of claims and other legal remedies is Section 61 of the Internal Revenue Code (IRC), which states that all income is taxable “unless there is a specific exception from any derived source, unless exempt by another section of the code. Perhaps the biggest exception to that rule comes into play with personal injury compensation agreements. The IRS excludes some income from lawsuits, settlements and tax awards, but not all.
If you get a settlement on a lawsuit, it could be for one of several reasons. Your agreement may constitute compensation for losses resulting from a physical injury or damages from another type of injury. 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. A lawsuit that arises from an injury that occurred in an accident may have more than one type of claim for damages.
Some of them are taxable, while others are not. In Certain Business Disputes, the IRS Taxes a Loss of Profits Settlement as Ordinary Income. Depending on the circumstances, compensation for loss of wages, unfair dismissal, or dismissal may be taxable as 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.
Clearly, the intricate rules are full of exceptions. Therefore, 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. Keep in mind that this does not include punitive damages, which the federal government taxes. The tax status of personal injury settlements can be confusing because compensation in personal injury cases often includes reimbursement of losses, such as lost wages, that would otherwise be taxable.
However, as long as the source of a claim arises from personal physical injury or physical illness, those compensatory damages are tax-free under Section 104 of the Tax Code. 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. Examples of non-visible injuries are sexual harassment, slander or defamation. 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, on the other hand, can involve physical symptoms, such as stomach pain, headaches, and stomach disorders, but they are not generally considered physical injuries or physical illnesses. Rather, a sign is perceptible evidence to the examining physician. In some circumstances, a court may award punitive damages.
The courts award these damages as a form of punishment for those responsible for the lawsuit. Courts generally award punitive damages when a defendant's actions involve scandalous behavior, such as fraud, malice, recklessness, or total disregard of the plaintiff's rights and interests. They are not awarded as compensation for the injured party's losses and are independent of compensatory losses. 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. This is true 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. Banks, the U.S. Supreme Court ruled that a plaintiff's taxable income is generally equal to 100 percent of their settlement. This is the case even if your lawyers take a 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 the courts in subsequent tax disputes, but the document should be as specific as possible about taxes. Most legal disputes involve complicated scenarios and multiple related problems. Even if your dispute is related to the main matter, the settlement may involve more than one consideration.
When the parties agree on tax treatment, although it is not binding, the IRS takes into account the parties' intention in determining whether to exclude a tax agreement. If the settlement agreement does not address taxes, the IRS will analyze the payer's intention to determine the tax status of settlement payments. In some cases, it is possible to allocate damages among several claims. For example, some damages can go to physical injury or illness, which are not taxable.
Others may pay for emotional distress, which is usually taxable. Consider potential tax implications when negotiating a settlement agreement and before signing it. Once you've signed the agreement, you won't be able to change it. During a lawsuit, most people's attention is primarily focused on the outcome and amount of compensation awarded.
As a relief from an early recovery, people may not consider the taxes you may have to pay on the settlement amount. By now, you've likely taken on countless challenges, such as enduring a painful recovery and financial losses. You and your lawyer have long fought for compensation that covers the full cost of your injuries. After dealing with physical and financial recovery from an injury, the last thing you want is to deal with the IRS.
The goal is for you to withhold as much of your settlement amount as possible to aid in your recovery. If you make money on a lawsuit, the IRS will be interested. The settlement will be taxable in some cases, as will the contingency fees owed to your attorney. However, most personal injury claim settlements and contingency fees for these cases are not taxable.
In the case of claims against a negligent builder for property damage, the settlement may be considered a reduction in the purchase price of the property rather than income, according to IRS guidelines. However, many agreements that arise out of business lawsuits are taxable. Compensation for physical injuries and ailments is tax-free. When a person experiences pain, suffering, and emotional distress from physical injury or illness caused by another party's negligence, that compensation is tax-free.
During agreement negotiations, you can negotiate to allocate a larger part of the agreement to non-taxable award categories. If you were injured in an accident caused by the negligence of another party, the legal process can often take months or years before an agreement or payment can be reached. If a significant portion of your settlement is awarded for punitive damages, you can expect to have a high tax liability that can drastically alter the final payment. In many cases, plaintiffs need the money from a lawsuit to pay unexpected costs, keep their business running, and address some of the damages they have suffered.
If your agreement includes compensation for lost wages or permanent loss of income due to physical injuries caused by the accident, this compensation can be taxed as if it were typical income. Most settlements are for various types of damages, such as loss of income, emotional distress, medical expenses, and other costs. Pain and suffering, along with emotional distress caused directly by a physical injury or ailment from an accident, are not taxable in a California or New York personal injury settlement. However, if you have received or expect to receive a large settlement, it is important to understand the financial impact following receipt of settlement funds.
Therefore, Forms 1099-MISC and Forms W-2, as applicable, must be filed and served to the plaintiff and attorney as the payee when attorney's fees are paid pursuant to a settlement agreement that provides for payments included in the claimant's income, even though only one check can be written for the attorney's fees. A decisive factor is whether your agreement involves personal injury in which there is “observable bodily harm.”. However, if there were no physical injuries, and the basis of the claim relates solely to the damage being mental or emotional distress, the state and the IRS are likely to pay taxes on those damages. The rules are full of exceptions and nuances, so be careful, how settlement awards are taxed, especially post-tax reform.