The Internal Revenue Service almost always expects its share whenever money changes hands, and money that comes as a result of a lawsuit is no exception. In many cases, the IRS considers this taxable income to you, although some lawsuit settlements and awards are tax-free. It depends on what the IRS calls the “origin of the claim,” and this can be complicated because many lawsuits have multiple components.
It’s Usually “Ordinary Income”
Lawsuit proceeds are usually taxed as ordinary income – they’re not subject to a special tax percentage rate just because the money comes as the result of litigation. The tax rate depends on your tax bracket.
As of 2018, you’re taxed at the rate of 24 percent on income over $82,500 if you’re single. If you have taxable income of $82,499 and you receive $100,000 in lawsuit money, all that lawsuit money would be taxed at 24 percent. The money bumped you up into that higher 24 percent tax bracket.
And what if your attorney charged you $40,000 for handling your case so you only actually pocketed $60,000? It doesn’t matter. The IRS takes the position that the lawsuit money was initially payable to you so you have to report the entire amount on your income tax return. You might be able to subtract some of the costs of winning your lawsuit, including attorney fees if you can claim them as a miscellaneous itemized deduction, but the Tax Cuts and Jobs Act passed in late 2017 eliminates and restricts a lot of these deductions, at least through 2025.
Capital Gains Tax
Some isolated lawsuits can result in capital gains tax. This is typically the case when the origin of the claim involves personal property. If the roofer you hired to repair your home does faulty work and your roof collapses a month later, this type of lawsuit money could fall into the category of capital gains.
This could be a good deal because you’d be charged the long-term capital gains tax rate if you owned the property longer than a year. This tax rate is 15 percent for most people, and the most you would pay is 20 percent. If you've held the property for less than a year, then you'd be taxed according to your federal tax bracket.
Taxation of Personal Injury Claims
Almost all origins of claim are taxable except personal injury lawsuits. If your claim is based on the fact that you were injured in a car accident or any other event, you won’t have to report this money as income or pay taxes on it. The same applies to the portion of your lawsuit that represents compensation for any medical bills you had to pay unless you itemized and took a tax deduction for those bills at the time you paid them. In that case, they must be separated out and you would have to report that portion of the lawsuit money as income.
Emotional Distress Claims
Until 1996, emotional distress claims were tax-free, too, but now the IRS says your injury must be “visible” to qualify. If you’re in an auto accident and end up having your spleen removed because of it, the IRS says this is good enough. The average person might not be able to see your injury, but it would show up on an X-ray. Developing an anxiety disorder due to the trauma of the accident isn’t visible so any money resulting from this type of claim would be taxable.
But what if you develop emotional issues because of the physical injuries you sustained? This is tax-free. And if you have to pay a psychiatrist to help you sort out trauma that isn’t related to your injury, any lawsuit money that compensates you for these medical expenses is tax-free as well, always assuming you never itemized and claimed a tax deduction for them.
If your lawsuit money is broken down into $60,000 for physical injury, $25,000 for emotional distress and $15,000 for medical expenses that you did not previously take a tax deduction for, $75,000 of your award or settlement would be tax-free.
Punitive damages are money awarded to the plaintiff – the wronged party in a lawsuit – if the defendant’s actions were so bad or so negligent that the court wants to punish him by tacking on an additional amount of lawsuit money. This is income to you and must be reported. If $90,000 of your award was due to physical injury and $10,000 was punitive damages, you’d have to report and pay taxes on the $10,000.
Lawsuits based on claims for lost wages are also taxable when you recover the money. If $60,000 of your award or settlement was for physical injury and $40,000 was meant to compensate you for income you didn’t earn because you were unable to work for nine months, that $40,000 remains taxable whether you earned it from your employer or the defendant had to compensate you for it. The same applies to employment-related claims such as if you sue your employer because you were unfairly terminated.