Sometimes when you've been harmed or wronged by someone, your only option is to file a lawsuit. If the defendant doesn't like his chances in a court of law -- or the court of public opinion -- he might offer you a settlement to make the conflict go away. That settlement might be tax free, or it might not. It all depends on the nature of the harm you've suffered.
Injuries and Sickness
Under federal tax law, all income from all sources is taxable unless specifically excluded from tax by the Internal Revenue Code. If you're receiving annuity payments on a lawsuit settlement, read Section 104 of the code, because it will be a big deal in your life. Section 104 says payments received as compensation for "personal physical injuries or physical sickness" are not taxable. It doesn't matter whether you receive payments as a lump sum or as a series of payments (an annuity, in other words). They're treated the same.
Any portion of your settlement payments that's not compensation for actual physical harm is generally considered taxable income. Payments intended to make up for lost wages or lost business income, for example, will be taxable (just like wages or business income you actually earned). The same is true for punitive damages. Since you're dealing with a settlement rather than a court judgment, the party who's paying you probably isn't admitting wrongdoing, so she's not going to acknowledge that any of the money is punitive. Nevertheless, if the settlement greatly exceeds your actual costs, expect the Internal Revenue Service to view some of the money as punitive damages. The way the law is applied, "emotional distress" counts as physical harm, so you won't be taxed for that amount.
Interest payments you receive are taxable income. Interest is commonly an issue with annuity settlements, since you don't receive your money all at once. Say you sue someone because of an injury you suffered, and you settle for $100,000. The defendant doesn't have all the money right now but agrees to pay $10,000 a year plus interest for 10 years. Since it's compensation for physical harm, the $10,000 principal in each payment isn't taxable, but the included interest will be taxed.
Attorneys' fees also complicate things. In general, you can take a tax deduction for legal fees only to the extent that the money you recover from your legal action is taxable. If you receive a taxable $100,000 settlement, for example, and you have $30,000 in lawyers' fees, you can deduct all your fees. If the settlement isn't taxable, you can't deduct the fees, because there's no taxable income to write them off against. If it's partially taxable, the amount you can deduct may be limited to the fees that can be allocated to the taxable portion of the settlement. These issues call for advice tailored to your specific situation. As "Forbes" recommends, include a tax professional in discussions of the settlement before you actually settle.
- Internal Revenue Service: Lawsuits, Awards and Settlements Audit Techniques Guide
- Internal Revenue Code via Cornell University Legal Information Institute: Section 104 -- Compensation for Injuries or Sickness
- Forbes: IRS Gets a Share of Most Legal Settlements
- The Oregonian: Are Lawsuit Settlements Considered Taxable or Non-Taxable Events?
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