Do You Get Taxed on Court Settlements?

Court settlements can significantly impact an individual’s financial situation, and understanding their tax implications is a common concern. The tax treatment of these funds is not uniform; it depends on the specific nature of the settlement. Various components within a settlement may be subject to different tax rules, making it important to analyze each element. This article clarifies how the Internal Revenue Service (IRS) approaches the taxation of court settlements.

Understanding Settlement Taxability

The IRS generally considers all income taxable unless a specific exclusion is provided by law. Internal Revenue Code (IRC) Section 61 broadly defines gross income. However, IRC Section 104 provides an exclusion for certain settlement awards. A settlement’s taxability hinges on the “origin of the claim,” meaning what the settlement was intended to replace.

Compensation for personal physical injuries or physical sickness is excluded from gross income under IRC Section 104. This exclusion applies to damages received through a lawsuit or settlement agreement. The IRS interprets “physical injury or sickness” to require observable bodily harm, such as cuts, bruises, swelling, or bleeding. Emotional distress does not qualify for this exclusion unless directly caused by a physical injury or sickness.

Tax Treatment for Common Settlement Components

The tax implications for various components of a court settlement differ, and understanding these distinctions is important for proper tax planning. The specific wording within a settlement agreement can influence how the IRS classifies payments.

Personal Physical Injuries or Physical Sickness

Settlements received for personal physical injuries or physical sickness are not subject to federal income tax. This exclusion covers compensation for medical bills, pain and suffering, and other compensatory damages directly related to the physical injury. Lost wages directly resulting from a personal physical injury or sickness are also excluded from gross income. However, if medical expenses were deducted in a prior tax year and provided a tax benefit, that portion of the settlement may become taxable upon recovery.

Emotional Distress

Compensation for emotional distress is taxable unless directly attributable to a physical injury or sickness. If emotional distress arises from a non-physical injury, such as workplace harassment without physical harm, the settlement for that distress is taxable as ordinary income. Medical expenses paid for emotional distress are excludable from gross income if not previously deducted.

Lost Wages or Lost Profits

Settlements or judgments that compensate for lost wages, lost business income, or lost profits are taxable as ordinary income. These amounts replace income that would have been taxable if earned normally. For employees, lost wages may be subject to income and employment taxes, similar to regular wages.

Punitive Damages

Punitive damages are taxable, regardless of the underlying claim, even if compensatory damages are tax-free. These damages are intended to punish the wrongdoer rather than compensate for a loss. They are reported as “Other Income” on Schedule 1 of Form 1040.

Property Damage

Compensation for property damage is not taxable if the amount received is less than or equal to the property’s adjusted basis. The adjusted basis is the original cost plus improvements, minus depreciation. If the settlement amount exceeds the adjusted basis, the excess is treated as a capital gain and is taxable. The property’s basis must be reduced by the settlement amount.

Interest

Any interest awarded on a settlement, whether pre-judgment or post-judgment, is taxable as ordinary income. This applies even if the underlying settlement amount is non-taxable. Interest income is reported on line 2b of Form 1040.

Attorney Fees

Attorney fees can complicate the taxation of settlements. The gross settlement amount, before attorney fees are deducted, is considered the plaintiff’s income for tax purposes. For certain claims, such as those involving unlawful discrimination or specific claims against the U.S. government, attorney fees may be deductible as an “above-the-line” adjustment to income on Schedule 1 of Form 1040. However, for most other cases, legal fees related to personal issues are not deductible.

Discrimination Settlements

Settlements arising from discrimination claims are taxable. Compensation for economic losses, such as back pay, and emotional distress not stemming from a physical injury are considered taxable income. However, medical expenses associated with emotional distress and emotional distress directly resulting from a physical injury in a discrimination case may be non-taxable. The IRS views back pay in discrimination cases as taxable wages.

Reporting Your Settlement Income

Receiving a court settlement involves reporting requirements to the IRS, even if portions are not taxable. Understanding these procedures helps ensure compliance with tax regulations.

The payer of a taxable settlement, particularly if it’s $600 or more and made in the course of their business, will issue Form 1099-MISC, “Miscellaneous Information,” to both the recipient and the IRS. This form reports various types of income, and taxable settlement proceeds are reported in Box 3, “Other Income.” It is important to review this form carefully as it informs the IRS about the payment.

In employment-related lawsuits, if a portion of the settlement represents lost wages or back pay, it is reported on Form W-2, “Wage and Tax Statement,” by the employer. This indicates that the amount is considered wages subject to federal income tax withholding and potentially Social Security and Medicare taxes. Even if employment has ended, these payments are still treated as wages.

Taxable settlement income is reported on Form 1040, U.S. Individual Income Tax Return. Income not reported elsewhere on Form 1040, such as most taxable settlement components, is reported on Schedule 1, “Additional Income and Adjustments to Income.” On Schedule 1, taxable settlement amounts are listed under “Other Income” on line 8z. Maintaining detailed records, including the settlement agreement and any accompanying documentation, is important for accurately reporting the income and supporting the tax treatment claimed.