Do You Have to Claim a Lawsuit Settlement on Your Taxes?
Navigate the complex tax rules for lawsuit settlements. Understand what's taxable, how to report it, and critical factors affecting your tax liability.
Lawsuit settlements often raise questions about tax obligations. The tax treatment of a settlement is not uniform; instead, it depends on the specific nature of the damages awarded. Understanding these distinctions is important to navigate the financial implications accurately and avoid unexpected tax liabilities.
Tax Treatment of Different Settlement Components
The taxability of a lawsuit settlement hinges on the “origin of the claim,” which refers to what the settlement is intended to compensate. The Internal Revenue Code (IRC) Section 61 states that all income is taxable unless specifically exempted. IRC Section 104 provides exclusions for certain settlement income.
Damages received on account of physical injuries or physical sickness are excluded from gross income. This exclusion applies to compensation for medical expenses, lost wages, and pain and suffering, provided these damages are directly linked to the physical injury or sickness. For example, if a settlement includes lost wages due to a physical injury, that portion is non-taxable.
Compensation for emotional distress not directly connected to a physical injury or sickness is taxable. However, if emotional distress arises from a physical injury, the damages for that distress can be tax-free. The IRS distinguishes between emotional distress that causes physical sickness and physical sickness that leads to emotional distress. The latter can be non-taxable with clear evidence of physical harm.
Payments for lost wages or lost profits are taxable because they replace income that would have been taxed if earned normally. This includes compensation for back pay, front pay, or severance pay, which are treated as wages subject to income tax and potentially Social Security and Medicare taxes. If the lost income relates to a trade or business, it is reported as business income.
Punitive damages are always taxable, regardless of the nature of the underlying claim. These damages are not intended to compensate for a loss but rather to punish the wrongdoer. Even if a settlement involves a physical injury that is otherwise tax-free, any punitive damages received will be subject to taxation as ordinary income.
Damages for damage to property are not taxable up to the adjusted basis of the property. The adjusted basis is the cost of the property plus improvements, minus depreciation. If the settlement amount exceeds the adjusted basis, the excess portion is considered a taxable gain.
Reporting Settlement Income on Your Tax Return
When you receive a lawsuit settlement, the taxable portions must be reported on your federal income tax return. The specific forms and lines used for reporting depend on the nature of the income received. Proper reporting is essential, even for non-taxable amounts, as the IRS may still be informed of the payment.
You might receive a Form 1099-MISC (Miscellaneous Information) for taxable settlement proceeds. This form is issued for payments of $600 or more, including punitive damages, emotional distress not linked to physical injury, or attorney fees paid directly to the attorney. Income reported on Form 1099-MISC is reported on Schedule 1 (Form 1040), line 8z, as “Other Income.”
If the settlement includes lost wages from an employment-related claim, the employer might issue a Form W-2 (Wage and Tax Statement). This income is reported like regular wages on Form 1040, line 1, and is subject to income tax withholding and employment taxes.
Even if no tax form is issued for a settlement, such as for a non-taxable physical injury settlement, you should maintain thorough records. This documentation can include the settlement agreement, court documents, and any correspondence detailing the nature of the damages. These records are important if the IRS inquires about the source of the funds.
Special Considerations for Settlements
Attorney fees are not deductible for individuals unless they relate to specific types of claims. An “above-the-line” deduction for attorney fees is available for certain types of claims, such as those involving unlawful discrimination or whistleblower awards, under IRC Section 62.
A structured settlement involves receiving payments over time rather than a single lump sum. If the underlying claim is for physical injuries or physical sickness, structured settlement payments are tax-free, including any interest earned. However, if the settlement is for a taxable claim, such as lost wages or punitive damages, each periodic payment will be taxable as ordinary income when received.
Any interest awarded on a settlement is taxable, regardless of whether the underlying settlement amount is tax-free. This includes pre-judgment and post-judgment interest. Interest income is reported on Schedule B (Form 1040), Interest and Ordinary Dividends.