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How are lawsuit settlements taxed?

        Money | Taxes

If you receive money from a lawsuit judgment or settlement, you may have to pay taxes on that money.
If you receive money from a lawsuit judgment or settlement, you may have to pay taxes on that money.

After months -- or even years -- of courtrooms and attorneys, you finally settle your lawsuit. The money you deserve is finally coming your way. But don't start celebrating just yet, because you may have forgotten one invitee to the party: the IRS.

If you receive money from a lawsuit judgment or settlement, you may have to pay taxes on that money. It depends on the circumstances of the lawsuit and, as is typically the case with taxes, can be confusing to sort out. Here are the general guidelines. (Note: You should always consult with a tax professional when you receive large amounts of money.)

After you collect a settlement, the IRS typically regards that money as income, and taxes it accordingly. However, every rule has exceptions. The IRS does not tax award settlements for personal injury cases. This means your injuries must be physical in nature. The IRS calls it "observable bodily harm," and states your injuries should be visible for your award to be tax-free [source: Wood].

You may or may not be taxed for settlements on cases that compensate you for emotional distress. Emotional distress on its own isn't a physical injury, and a lawsuit settlement for emotional distress would be taxed as income. However, if you sought medical attention for emotional distress, such as sessions with a counselor, those sessions may be tax-free. With nonpersonal injury awards, the IRS does tax the money as income. Lawsuit items like the following are therefore taxable [source:]:

  • Interest on monetary awards
  • Most punitive damages
  • Most payments for lost wages or lost profits
  • Damages for emotional distress
  • Damages for Title VII (Civil Rights Act) cases
  • Damages for patent or copyright infringement or breach of contract
  • Money received for settlement of pension rights
  • Attorney fees and costs if they are awarded as part of the settlement

For example, if you sue a competing business and receive a settlement for lost profits, that settlement is taxed as income. If your employer fires you and you sue and win for discrimination, your back wages are taxed as income. In lawsuit cases such as shoddy building repair, however, your settlement would be reported as a reduction in the purchase price of your home.

Be aware of your attorney fees as well. Here's an example. Say you sue your ex-spouse for emotional distress for $200,000 and win. Your attorney keeps $80,000 as her fee, so you end up with $120,000. It would seem logical to claim $120,000 on your taxes as income. However, the IRS requires you claim the entire $200,000, and then an $80,000 miscellaneous itemized deduction [source: Wood].

The bottom line is that the IRS taxes most money you win in a lawsuit as income. If you're involved in a lawsuit, experts recommend you work with your accountant and attorney beforehand to ensure you don't run into any problems with Uncle Sam.