As a tax attorney, I am often asked this question after a prospective client has received an overdue tax notice. The person on the other line is usually in a panic as they claim they had no idea that their particular settlement could be considered taxable.
Aren’t all settlements nontaxable?
My attorney never told me that.
Opposing Counsel lied to me!
Fortunately, the taxability of a particular settlement is usually, or at least should be, written into the settlement agreement along with a provision that the plaintiff’s accountant is allowed to view the agreement to ensure appropriate reporting come tax season.
THE GENERAL RULE
The general rule is that gross income includes income from whatever source derived unless specifically excluded under the internal revenue code.
LAWSUIT SETTLEMENTS & AWARDS
The internal revenue code has carved out some exceptions to the general rule for lawsuit settlements and awards, but the following applies to all settlements and awards:
- All interest on awards is taxable; and
- All punitive damages, which are intended to punish or make an example of the defendant, are taxable except in certain wrongful death actions.
Personal Injuries. Compensatory damages, which are amounts paid to compensate for actual loss or injury, received for personal physical injury or sickness are not taxable. Also, damages for loss of wages or earnings, loss of earning capacity, and for emotional distress are nontaxable if caused by a physical injury or sickness.
Emotional Distress. Damages for emotional distress are taxable if not caused by physical injury or sickness even if the distress causes physical symptoms. The only exception is that damages paid that cover the cost of deductible medical care are excluded from income.
Other Claims. Taxability of a lawsuit settlement or award depends on the item the settlement replaces. If the item would be taxable income, the settlement or award is taxable as well. Below are some further examples:
- Class action and other settlements for consumer goods or services.
- Property damages where the amount received does not exceed basis.
- Damages for nonphysical injuries such as discrimination, defamation, libel, slander, etc.
- Workman’s compensation and other claims against employers.
- Damages for most business and contract claims.
This article simply serves as a primer and is not inclusive of all causes of action. Make sure you discuss the tax implications of any settlement with your attorney prior to signing on the dotted line.
Alex Curcuru is the managing member of The Alexander Law Firm, LLC. Mr. Curcuru provides advice on a wide-range of tax issues and handles disputes with the IRS and Missouri Department of Revenue for both individuals and businesses. He can be reached at (314) 261-4111 and [email protected].