Is Court Awarded Money or a Settlement Taxable?

The taxability of money received from a court award or settlement is a common area of confusion for many individuals. It is often assumed that such funds are automatically exempt from taxation, but this is not always the case. The tax treatment of these awards depends primarily on the underlying reason for which the money was granted. Understanding these distinctions is important for proper financial planning and compliance with tax regulations.

General Rules for Court Awards

Under federal tax law, all income from any source is considered taxable unless a specific exclusion is provided by law. This principle extends to money received through court awards, judgments, or out-of-court settlements. The Internal Revenue Service (IRS) generally views these amounts as income unless a specific provision in the tax code states otherwise. Therefore, money from legal actions is presumed taxable until a specific exclusion applies.

The taxability of an award is determined by the nature of the claim and the purpose for which the funds were received, not simply by the fact that the money originated from a legal proceeding. For instance, if an award compensates for lost wages, it is treated as taxable income because wages would have been taxable if earned directly. Conversely, if the award replaces a non-taxable item, it may also be non-taxable. This “origin of the claim” doctrine is a factor in determining the tax implications of settlement or judgment proceeds.

Awards for Physical Injuries and Sickness

Awards received on account of personal physical injuries or physical sickness are excluded from gross income. This exclusion applies to damages received, whether by suit or agreement, as a lump sum or as periodic payments. For the exclusion to apply, the injury or sickness must be physical. This includes compensation for medical expenses directly related to the physical injury or sickness.

The exclusion also covers amounts received for pain and suffering or emotional distress directly attributable to a personal physical injury or physical sickness. For example, if a car accident causes a broken leg and subsequent emotional distress, the entire award for both the physical injury and the related emotional distress would be non-taxable. However, the physical injury must be discernible, meaning it must be an observable bodily harm. This distinction is important because emotional distress alone, without a direct link to a physical injury, is treated differently for tax purposes.

It is important to maintain detailed records, such as medical reports and settlement agreements, to substantiate that the award was for physical injuries or sickness. Internal Revenue Code Section 104 outlines this exclusion, providing a legal basis for the non-taxable treatment of these awards.

Awards for Non-Physical Injuries and Other Damages

Awards for emotional distress are taxable unless they directly resulted from a personal physical injury or physical sickness. For example, an award for emotional distress stemming from defamation or employment discrimination, where no physical injury occurred, would be included in gross income. The IRS considers such awards compensation for non-physical harm. This distinction emphasizes the direct causal link required for the physical injury exclusion to apply.

Punitive damages are always taxable, regardless of the nature of the underlying claim. These damages are awarded not to compensate the injured party, but to punish the wrongdoer for egregious conduct and to deter similar actions. Even if compensatory damages in a lawsuit are for personal physical injury or sickness and are non-taxable, any portion of the award designated as punitive damages must be included in the recipient’s gross income.

Awards intended to replace lost wages or income are taxable, just as the original wages or income would have been if earned directly. This category includes back pay, front pay, and compensation for lost profits. For instance, if a settlement includes an amount for wages an individual would have earned but for a wrongful termination, that portion is taxable income. This is consistent with the principle that income replacement awards maintain the tax character of the income they are replacing.

Other types of awards are taxable. For example, damages received for breach of contract are taxable. Awards for property damage are taxable to the extent they exceed the adjusted basis of the damaged property. If a property is destroyed and the award exceeds its original cost or adjusted value, the excess amount could be considered a taxable gain. These categories highlight the scope of Internal Revenue Code Section 61, which broadly defines gross income.

Specific Components of Court Awards

Interest received on any court award or settlement is taxable, regardless of whether the underlying award itself is taxable or non-taxable. For example, if a non-taxable physical injury award accrues interest from the time of injury until payment, that accrued interest portion must be included in the recipient’s gross income. This is because interest is considered income derived from the use of money, separate from the principal award. The payer may report this interest to the IRS on Form 1099-INT.

The tax treatment of attorney fees within a settlement requires careful consideration. If the attorney receives a portion of the award directly as a contingent fee, the entire gross award—before the deduction of attorney fees—is considered income to the taxpayer. This means that even if the taxpayer never physically receives the portion paid to their attorney, that amount is included in their taxable income.

In some cases, attorney fees may be deductible. For instance, fees paid in connection with a claim of unlawful discrimination or certain whistleblower claims may be deductible “above-the-line,” reducing adjusted gross income. For other types of cases, attorney fees may not be deductible. Understanding the specific nature of the legal claim is important for determining the tax treatment of attorney fees.

Reporting Court Awards

Taxable court awards or settlements may be reported to the IRS by the payer. Depending on the payment’s nature, this reporting occurs on Form 1099-MISC (Miscellaneous Income) or Form 1099-NEC (Nonemployee Compensation). For example, if a settlement includes taxable lost wages, it might be reported on Form 1099-NEC. If it includes other taxable income, like punitive damages or taxable emotional distress, it might appear on Form 1099-MISC. Recipients should expect these forms if their settlement includes taxable components.

It is important for individuals receiving court awards or settlements to maintain detailed records. This documentation should include the original complaint, settlement agreement, judgment orders, and any correspondence related to the nature of the damages. These records are important for substantiating the tax position taken on a tax return, especially if the IRS questions the non-taxable portion of an award. Clear documentation helps demonstrate the specific allocation of funds within a settlement.

Given the complexities of determining the taxability of court awards, consulting with a qualified tax professional is often beneficial. A tax professional can help analyze settlement details, correctly identify taxable and non-taxable portions, and ensure proper reporting to the IRS. This guidance can help individuals navigate their tax obligations and avoid potential issues with tax authorities.