A big question on the minds of litigants after months or potentially years of legal battles is whether their settlements are taxable. Whether settlements are taxed is dependent on your circumstances. Before you begin spending any settlement money, you need to figure out whether you will need to pay taxes to the IRS. Depending on the type of lawsuit, it can be a bit difficult to tell whether your settlement will be taxed. This makes it essential to consult a tax expert whenever you receive settlements or other large sums of money. Otherwise, you could end up in serious trouble with the IRS.
After Collecting Your Settlement
Once you have been paid, the IRS is likely to consider your settlement money as income. This means it will be taxed as such. This rule has some exceptions. The IRS does not tax any settlements in personal injury lawsuits. Your injuries need to be physical, however, to be given this leeway. The IRS calls this “observable bodily harm” and requires your injuries to be visible. Otherwise, you may need to pay taxes on your award settlement. If it is not clear whether your injuries qualify, ask your attorney and your accountant.
Settlements based on emotional distress can be a different story. Depending on the specifics of your case, your compensation can be taxed or exempt. Usually, emotional distress is not considered a physical injury and is, therefore, taxable. However, there is an exception. If you seek medical attention because of emotional pain, your settlement may be exempt. This includes counseling sessions and other forms of psychiatric or psychological care. Make sure to keep documentation showing the costs and reasons for these mental health sessions so you can prove that your distress warrants an exemption for these costs.
Types of Taxable Settlements
The IRS is pretty clear about what it considers taxable. While the IRS has some exemptions for specific types of settlements, the general rule is that cash awards are taxable. The IRS taxes non-personal injury award settlements as income and taxes them accordingly. This makes many types of settlements taxable, including:
- The majority of punitive damages
- Interest from settlements
- Most lost profits and lost wages payments
- Settlements for emotional distress
- Pension settlements
- Copyright infringement, patent, and breach of contract settlements
- Title VII (Civil Rights Act) settlements
- Attorney fees and legal costs that are part of settlements
Settlements between competing businesses for lost profits are taxed, as are discrimination lawsuits for back wages. In other cases, such as dangerous or damaged building repair, the settlement is reported to the IRS as a reduction in the property’s purchase price. The entire settlement is taxable as income, not only the part you keep. So while you may win $200,000 and pay $100,000 to your attorney, you will be taxed on the entire $200,000. The IRS requires you to list legal and attorney costs as miscellaneous itemized deductions.
Better Safe Than Sorry
If you are unsure whether your settlement is going to be taxed, consult a tax professional. It is better to make sure before spending award money lest you end up in trouble with the IRS. Tax experts recommend that you consult your accountant and attorney before doing anything with your collected settlements. It is more likely than not that the IRS will consider your settlement as income and tax it accordingly. However, knowing your rights and responsibilities in dealing with the IRS is key to making sure you do not get yourself into legal trouble.