Do You Have to Claim a Settlement on Your Taxes?
Decipher the tax rules for settlements. Learn which types are taxable, how to report them to the IRS, and what records to keep for clarity.
Receiving a settlement often introduces questions about tax obligations. The taxability of settlement funds is not always straightforward, depending on the specific nature of the compensation. Understanding these tax implications is important to avoid unexpected financial burdens.
Understanding Settlement Taxability
The principle determining whether a settlement is taxable revolves around “what the settlement replaces.” If a settlement compensates for something that would have been taxable income, it is generally taxable. Conversely, if it replaces a non-taxable item, it may also be non-taxable.
Damages received for physical injury or sickness are generally excluded from gross income. This exclusion applies to amounts for medical expenses, pain and suffering, and other losses directly related to the physical harm. For this exclusion to apply, there must be observable bodily harm, such as bruising, swelling, or bleeding.
Emotional distress damages are generally taxable unless directly attributable to a physical injury or sickness. If emotional distress arises from a physical injury, compensation for it is not taxed. However, compensation for emotional distress not linked to a physical injury, such as in cases of defamation or humiliation, is taxable.
Medical expenses incurred due to emotional distress may be excludable from income if not previously deducted. If these expenses were deducted in a prior year, reimbursement in a settlement is taxable to the extent of the prior deduction.
Settlements for lost wages, lost profits, or other income replacement are generally taxable. These amounts substitute for income that would have been taxed if earned normally. Therefore, they are subject to income tax, and sometimes employment taxes like Social Security and Medicare.
Punitive damages are always taxable income, regardless of the underlying claim. These damages punish the wrongdoer rather than compensate the injured party for a loss. The Internal Revenue Service (IRS) views punitive damages as a penalty, making them fully taxable.
Any interest awarded as part of a settlement is taxable income. This applies to both pre-judgment and post-judgment interest. The IRS views interest as income earned on the settlement amount, similar to interest earned on a savings account.
Attorney fees are often included in the gross settlement amount for tax purposes, even if paid directly to the attorney. The full settlement amount, including the portion paid to the attorney, may be considered income to the recipient before any deductions. Taxpayers often cannot deduct legal fees for taxable portions of their settlements.
Reporting Taxable Settlements
When a settlement includes taxable components, it is important to understand how these amounts are reported to the IRS. Taxable settlements are reported by the payer using specific information returns.
Taxable settlements of $600 or more are reported on Form 1099-MISC, Miscellaneous Information. This form is used for various income types, including certain lawsuit settlements, punitive damages, and other taxable payments not classified as wages. The payer sends a copy to both the recipient and the IRS.
If a settlement is for back wages or other employment-related income from an employer, the amount may be reported on Form W-2, Wage and Tax Statement. This form indicates the settlement is treated as taxable wages, subject to income and employment tax withholding. The form reflects the gross amount of taxable wages.
Once the taxability of a settlement component is determined, individuals must report these amounts on their personal income tax return, Form 1040. Taxable wages reported on Form W-2 are included on Line 1 of Form 1040. Other taxable settlement income, such as punitive damages or emotional distress not linked to physical injury, is reported on Schedule 1 (Form 1040), Line 8z, “Other Income.”
Receiving a large taxable settlement might create a significant income increase for that tax year. To prevent underpayment penalties, individuals may need to make estimated tax payments throughout the year. The IRS provides guidance on estimated taxes, which are paid quarterly, to cover tax liabilities not subject to withholding.
Essential Records for Settlements
Maintaining comprehensive records related to a settlement is important for accurate tax reporting and in case of IRS inquiries. These documents provide proof of the nature and allocation of settlement funds.
The full settlement agreement is a primary document to retain. This agreement details the parties involved, the specific claims being settled, and the breakdown and allocation of damages. A clear allocation within the agreement supports the tax treatment of different settlement components.
Legal correspondence with attorneys or other involved parties that clarifies the purpose or allocation of settlement funds should be kept. This includes letters, emails, or internal memos that shed light on the intent behind payments. Such documentation is valuable in substantiating the tax position taken.
For claims involving physical injury or sickness, retaining medical records and bills is important. These documents help substantiate that the excludable portion of the settlement was for physical injuries or related medical expenses. This evidence supports the non-taxable nature of those funds.
Copies of information returns received, such as Form 1099-MISC or Form W-2, are essential. These forms reflect what the payer reported to the IRS, and having them allows for accurate reconciliation with the tax return. If a form is received for an amount believed non-taxable, keeping all supporting documentation is important.
Other supporting documents include invoices for property damage, evidence of lost wages, or documentation of treatment for emotional distress if related to a physical injury. These records collectively provide a complete picture of the events leading to the settlement and the specific damages compensated.
Taxpayers should keep records supporting income, deductions, or credits shown on a tax return for at least three years from the filing date or two years from the tax payment date, whichever is later. For substantial understatements of income (more than 25% of gross income), the IRS can look back six years. It is advisable to keep copies of tax returns indefinitely.