When you receive a settlement from a lawsuit, it is important to understand the tax implications. The proceeds of the lawsuit are generally taxed as ordinary income, and the tax rate depends on your tax category. However, damages for physical injury are not considered taxable income. In addition, in some cases, you cannot deduct legal fees from your tax base.
The IRS allows settlements won in a personal injury case to be excluded from gross income when filing taxes. This tax-free status applies to both lump sum and periodic payments. In general, the IRS taxes settlements based on the source of the specific claim, which depends on the reason for the claim that formed the basis for the settlement. Structured settlements and lump-sum payments for compensatory damages in personal injury cases are tax-exempt.
If you are required to pay taxes on the money in the settlement of the lawsuit, you will be taxed at standard income rates set by the federal government. The long-term financial security provided by structured settlements reduces the burden on public assistance programs. Consider potential tax implications when negotiating a settlement agreement and before signing it. Injured parties will never pay taxes on the structured settlement money awarded in these cases, regardless of whether they receive the money in a series of payments or if they sell their payments for a lump sum.
Although legislators prefer people to keep their structured agreements, there are no negative tax consequences to selling settlement payments. Request copies of the original petition, complaint, or claim filed that demonstrate the reasons for the complaint and the agreement to resolve the complaint. Structured settlements are intended to provide regular income to the injured party by distributing payments over several years, rather than distributing the money as a single lump sum, which could be badly spent.