The IRS has not been clear on whether or not settlements are taxable. The answer to this question is not always straightforward.
Settlements can be taxable in some cases, but there are also many instances where they are not. It is important to consult with an attorney to find out if your specific settlement is taxable.
Are settlements taxable? Whether or not a settlement is taxable depends on the type of settlement. If the settlement is reached through mediation or some other form of alternative dispute resolution, it is typically not taxable. If the settlement is reached through a lawsuit, however, it may be considered taxable income.
To find out for sure, you should speak to an experienced tax lawyer.
Are Settlements Taxable?
The basic rule for taxable amounts received as the result of civil lawsuits and other legal settlements is Internal Revenue Code (IRC) Section 61, which states that all income is taxable unless specifically exempted by another part of the tax code.
The IRS has a very specific exemption in the IRC Section 104 that protects you from paying taxes on lawsuits, settlements, and awards.
However, to determine the purpose for which the money was received, the facts and circumstances surrounding each payment must be evaluated since not all settlement payments are tax-free.
- IRC Section 61: Says that all amounts from any source are taxed in gross income unless there is a specific exemption. The two most frequent exceptions for damages are payments made for certain discrimination claims, as well as payments made on account of physical injury.
- IRC Section 104: Gross income does not include compensation for personal physical injuries and bodily injuries.
- IRC Section 104(a)(2): exception allows a person to subtract from their taxable income “the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal injuries or physical sickness.”
- Reg. Section 1.104-1(c): “damages received on account of personal physical injuries or physical sickness” refers to an amount obtained (other than workers’ compensation) through the prosecution of legal action or settlement agreement, which is intended to compensate the plaintiff for losses sustained as a result of personal physical
Calculating Tax on settlements
The tax consequences of receiving a lawsuit settlement are dependent on the sort.
- Damages from physical damage aren’t taxable revenue in general. However, if you’ve already subtracted, for example, your medical expenditures from your accident expenses, your damages will be taxable. You won’t receive the same tax benefit again.
- In some situations, you may be awarded compensation for a hurt that isn’t physical. For example, if you win a libel case and are compensated for the specialists you consulted about your stress-induced headaches as a result of being libeled, the medical expenses incurred as a result of those statements are not taxable.
- Although emotional suffering is typically taxable, if the emotional distress is caused by a physical injury or manifests in physical symptoms for which you seek treatment, it is not subject to taxation.
- Punitive damages, back pay, and interest on unpaid money are all taxable in most cases. Emotional distress damages are also taxable, with the exceptions described above.
- The worst part is that you’re not only responsible for paying taxes on the entire amount you earn, but also any attorney costs. That’s correct – no matter whether or not you take the cash home, it’s still a component of your award and subject to taxation. And if the other party has to pay your legal fees, those fees are taxable
How to file settlements on your federal and state taxes?
Unless there is a law that specifically excludes a portion of it from your gross income, you must disclose all of your earnings to the IRS. Unless any exemptions apply, the issue of whether you need to pay state and federal tax depends on whether any allowances are available.
- Any money paid to reimburse you for lost wages is taxed if the funds are used to settle an employment-related legal matter. These funds are subject to employer withholding taxes. You would report these earnings on Line 7 of your 2017 Form 1040.
- Any interest paid to you on any settlement funds is generally taxed. It should be entered on Line 8a of Form 1040 as taxable income.
- Punitive damages awarded as a result of your legal case are also taxable. This money should be shown on Line 21 of Form 1040.
The IRS’s basic rule for taxes on payments received as the result of a lawsuit or other legal settlement is Internal Revenue Code Section 61, which says that all income is taxable from whatever source derived unless specifically exempted by another section of the tax code.
This means that any money you receive as part of a legal settlement – whether it be through a court judgment, an insurance payout, or some other form – is generally subject to federal income tax.
However, there are some exceptions to this general rule, and you should speak with an accountant or tax lawyer if you have any questions about how these rules might apply to your specific case. At the very least, understanding Section 61 should help you when negotiating any settlements of your own.