Are Legal Judgements Considered Taxable Income?

Legal judgments and settlements provide financial compensation. Their tax treatment is not always straightforward, depending on the claim’s nature and damages awarded. Understanding these distinctions is important for tax planning and compliance.

Understanding Judgment Taxability

The “origin of the claim” doctrine guides the taxability of judgment awards. This doctrine dictates that a settlement or judgment’s tax treatment depends on the underlying claim’s nature, not how the payment is structured or labeled. The Internal Revenue Service (IRS) considers all income taxable unless specifically exempted. Therefore, if the claim originates from an issue that would result in taxable income, the judgment award is usually taxable.

When applying the “origin of the claim” test, courts often ask, “In lieu of what were the damages awarded?”. This question helps determine whether the payment replaces a form of income that would have been taxable or compensates for a loss that is not considered income. For instance, if a judgment compensates for lost wages, which are ordinarily taxable, then the judgment amount representing those wages will also be taxable. Conversely, if an award compensates for a non-taxable loss, such as physical injury, the award is generally not subject to tax.

The IRS views different types of income differently, extending these distinctions to judgment awards. Compensatory damages aim to make the injured party whole, while punitive damages punish the wrongdoer. The payment’s purpose significantly influences its tax status. Proper documentation of the settlement agreement, clearly allocating amounts to specific damages, is important for establishing the award’s tax treatment. Without clear allocation, the entire amount may default to being taxable.

Common Taxable Judgment Awards

Several types of judgment awards are considered taxable income. Awards for lost wages or lost profits are taxed because they replace income that would have been taxable. For example, compensation for back pay or unpaid wages from an employment-related lawsuit, such as wrongful termination, is treated as ordinary income and may be subject to both income and employment taxes. Similarly, lost business profits awarded in a judgment are taxable as business income.

Punitive damages, awarded to punish a defendant for egregious conduct rather than to compensate the injured party, are fully taxable. This applies regardless of whether the underlying claim involved physical injury or sickness. Interest accrued on a judgment award (pre-judgment or post-judgment) is also taxable as ordinary income. This is because interest is considered compensation for the delay in receiving funds and is viewed as income itself.

Emotional distress awards not stemming from a physical injury or sickness are taxable. While emotional distress can manifest in physical symptoms like headaches, these are not considered physical injuries by the IRS unless there is observable bodily harm. If emotional distress results from discrimination or defamation without an accompanying physical injury, the compensation received is taxable.

Common Non-Taxable Judgment Awards

Certain types of judgment awards are not considered taxable income by the IRS. Awards for personal physical injuries or sickness are excluded from gross income. This includes compensation for observable bodily harm such as broken bones, bruising, or illnesses. The exclusion applies to both economic and non-economic damages directly related to the physical injury.

Compensation for medical expenses, including past and future medical care, arising from a physical injury or sickness is non-taxable. However, if a taxpayer previously deducted these medical expenses on a prior tax return and received a tax benefit, the portion of the judgment repaying those previously deducted expenses becomes taxable. This is due to the tax benefit rule, which requires income inclusion for amounts previously deducted and providing a tax advantage.

Damages for emotional distress or mental anguish are non-taxable only if directly attributable to a physical injury or sickness. For example, if emotional distress results directly from a physical injury sustained in an accident, the related award is non-taxable. Awards for property damage are non-taxable to the extent they restore the taxpayer’s basis in the property. If the award exceeds the adjusted basis of the damaged property, the excess amount is considered taxable income.

Reporting Judgment Income

Once a judgment award’s taxability is determined, the next step involves properly reporting the income to the IRS. Taxpayers receive various forms depending on the taxable award’s nature. For miscellaneous income, such as certain taxable settlements or punitive damages, a Form 1099-MISC is issued by the payer. Taxable emotional distress awards and punitive damages are reported in Box 3 of Form 1099-MISC as “Other income”.

If the judgment award includes compensation for lost wages or back pay, particularly in employment-related cases, it is reported on a Form W-2, similar to regular wages, with applicable employment taxes withheld. In other instances, especially if the payment is non-employee compensation, a Form 1099-NEC is issued. The distinction between these forms is important, as a Form 1099-NEC implies self-employment tax obligations.

Taxable judgment income is reported on an individual’s Form 1040. Wages reported on a Form W-2 are entered on Line 1 of Form 1040. Other taxable settlement income, not classified as wages, is reported on Schedule 1 (Form 1040), Line 8z, as “Other income”. If a Form 1099-MISC is received, its information is used to enter the settlement amount in the appropriate section of the tax return. Maintaining detailed records of the settlement agreement and any allocations made within it is important for tax reporting.