Legal disputes can be long and stressful. You may have been in a car accident or wrongfully let go from your job. Most of the time, these disputes are resolved monetarily—according to Black’s Law Dictionary, 95 percent of lawsuits end in settlement prior to trial and more than 90 percent of cases that end in trial result in a judgment for the plaintiff. But when the legal battle is over, and the settlement is paid, there is one last hurdle you’ll have to face: taxes.
The taxability of your settlement will be determined by the origin of the claim. This essentially refers to the cause that led to your legal settlement. Like most tax regulations, there are general rules with numerous exceptions. So, if you received a settlement, do you need to pay taxes on it?
Is your settlement for a physical injury or sickness?
If your settlement was due to physical injury or sickness, it will not be taxed. But there are certain standards you must meet before the IRS in earning this classification. The agency has ruled that these injuries must be observable, such as cuts or bruises, to qualify as physical. The IRS also specifies that taxes do need to be paid on a portion of the settlement for medical expenses, if you deducted those medical expenses in prior years. If you sustained lasting health consequences or the loss of a limb after a train accident, for example, you can be confident that your settlement won’t be counted as income.
“I generally tell clients that a personal injury settlement isn’t taxed,” says Chris Sallay, a personal injury attorney with Queller, Fisher, Washor, Fuchs & Kool. “The money is making them whole for the injuries sustained.”
A physical injury that results in wrongful death funds to an estate may be taxed if the estate exceeds the estate value threshold, but this would fall under estate tax law and not under income tax.
Is your settlement for emotional distress?
When it comes to emotional distress, there are generally two circumstances that determine taxability.
If the proceeds of your settlement were awarded for emotional distress originating from a physical injury, then they are tax exempt. If they did not originate from a physical injury, they are taxable. If they are taxable, the amount you include on your taxes can be reduced by your medical expenses even if they were previously deducted—as long as they did not provide a tax benefit.
In some jurisdictions, however, the cause of your emotional distress might not matter. A physical component will always be required for your settlement.
“Generally, in New York, you have to have a physical injury to claim emotional distress,” Sallay says. While this rule has a few specialized exceptions, this distinction of origin doesn’t always apply.
Is your settlement regarding lost wages or loss of profit?
Settlements for lost wages and profit are taxed. If you had received your wages and profit as you should have, they would have been subject to tax, so receiving them as a legal settlement doesn’t get you preferential treatment. There is an exception for a loss of wage claim when it occurs due to a physical injury or sickness, like if you were unable to continue working after a disability, or fired after being hurt on the job. In these cases, it would fall within the category of the physical injury regulations and would not be taxed.
Is your settlement for a loss in value of property?
If a contractor did sub-standard work causing your bathtub to drain improperly and resulted in water damage, you may have received a settlement that is for loss in value of property. If the amount you were awarded in that settlement is less than what you originally paid for the damaged property, you won’t be taxed for the payment. If the amount in damages is more than what your original property was worth, however, your settlement will be subject to tax.
Punitive damages and interest are always taxable
There are complicating circumstances if your settlement includes punitive damages or interest—this portion of money is taxable even if received regarding a physical injury. For instance, you could be awarded $100,000 in compensatory damages and $200,000 in punitive damages for a physical injury, meaning the $100,000 is tax exempt, but the $200,000 is taxable. This means that the money you receive may fall under multiple damage categories (e. g. compensatory and punitive), so it is best that the money amounts for various categories be clearly defined in the settlement process.
Taxable settlements include attorney’s fees
If your money is taxable, you will be taxed on the gross amount of the settlement. For example, if you received $100,000 as a settlement and then paid $40,000 in attorney’s fees, you will need to report the $100,000 as income even though you only received $60,000. The attorney’s fees can be deducted under miscellaneous deductions if you receive the settlement as an individual. If the settlement relates to your business, the deduction is an above-the-line deduction. Whistleblower and discrimination awards also can use an above-the-line deduction.
Don’t figure out your settlement taxes alone
Every legal settlement circumstance is different, so if you’ve received a settlement it’s in your best interest to consult with your attorney about the origins of your claim. Armed with this knowledge, you can go to your CPA with the settlement agreement or closing statement. These documents should clearly outline what type of damages you received and will make it easier for your CPA to determine what money is taxable and what is not. Once the IRS is satisfied, you can work towards getting back to a normal life.