Are All of Your Court Winnings Taxable?

The tax implications of court winnings are often complex. Whether funds received from a legal case are taxable depends largely on the nature of the award. Understanding these distinctions is important for proper tax compliance and financial planning.

Understanding Taxable Court Winnings

Under U.S. tax law, Internal Revenue Code Section 61 states that gross income includes all income unless specifically excluded. This means court winnings are generally taxable. An award’s taxability hinges on the “origin of the claim” doctrine, which examines what the payment was intended to replace. If the payment replaces something that would have been taxable, the award is likely taxable.

This rule applies whether money is received through a lawsuit judgment or an out-of-court settlement. The IRS scrutinizes the underlying reason for the payment. Identifying the specific purpose of the award is the first step in understanding its tax implications.

Tax Treatment of Different Award Types

The taxability of court awards varies significantly based on the type of damages received. Certain awards are excludable from gross income, while others are fully taxable. The distinction often lies in whether the award compensates for physical injuries or sickness.

Physical Injuries and Sickness

Damages received on account of physical injuries or sickness are generally not included in gross income under Internal Revenue Code Section 104. This exclusion covers compensation for medical expenses, lost wages, and pain and suffering directly related to a physical injury. For example, if an award covers hospital bills or lost income due to an injury sustained in an accident, these amounts are typically not taxable.

Emotional Distress

Emotional distress damages are generally taxable, unless they are directly attributable to a physical injury or sickness. If emotional distress arises from a physical injury, then the associated damages may be excludable from income. However, emotional distress, by itself, is not considered a physical injury or sickness for tax purposes.

Punitive Damages

Punitive damages, which are awarded to punish the at-fault party rather than compensate for a loss, are always taxable. The IRS views these as income.

Lost Wages or Profits

Awards for lost wages or lost profits that do not stem from a physical injury are taxable as ordinary income. Since these amounts replace income that would have been taxed if earned, they are subject to federal and, in some cases, state income taxes. This can also include Social Security and Medicare taxes.

Property Damage

If an award compensates for damage to property, it is taxable only to the extent that the award exceeds the adjusted basis of the property. For instance, if property with an adjusted basis of $10,000 is damaged and the award is $12,000, the $2,000 difference is a taxable gain. If the award is less than or equal to the adjusted basis, it typically is not taxable.

Interest

Any interest received on a court award is always taxable as ordinary income. This applies to both prejudgment and post-judgment interest, even if the underlying award itself is not taxable. Interest is reported separately from the main award.

Attorney Fees

Attorney fees paid from a taxable award generally are not deductible as an itemized deduction for individuals for tax years 2018 through 2025. While some exceptions exist for specific types of cases, for most taxable awards, the plaintiff is taxed on the gross amount of the award, even the portion paid directly to the attorney.

Reporting Court Winnings for Tax Purposes

Recipients of taxable court winnings must correctly report these amounts on their federal income tax returns. The payer of the award may issue various tax forms depending on the payment’s nature. For instance, Form 1099-MISC is commonly used for taxable settlement amounts, while Form W-2 might be issued if lost wages are paid by an employer as part of a settlement.

Taxable punitive damages, emotional distress awards not tied to physical injury, and other taxable components are typically reported as “Other Income” on Schedule 1 (Form 1040). Lost wages reported on a Form W-2 go on Form 1040, similar to regular wages. Otherwise, they may also be reported as “Other Income.”

Individuals receiving large court awards should consider making estimated tax payments throughout the year. This helps prevent potential underpayment penalties, as taxes may not be withheld from these winnings by the payer. Estimated taxes can be paid quarterly using Form 1040-ES.

Maintaining thorough records related to the court case and the award is important. This includes copies of settlement agreements, court orders, and any tax forms received from the payer. Such documentation is essential for accurately preparing a tax return and for responding to any IRS inquiries.