Winning a lawsuit can help replace money you lost, but before you start spending, make sure you account for Uncle Sam's share. Generally, the lawsuit proceeds maintain the same tax character as the item the settlement replaces. If the lawsuit money covers multiple categories of damages, you need to get a breakdown of how much went to each damage type.
Lawsuit damages you win for physical injuries or medical fees are not taxable. For example, if you win a settlement for $10,000 to cover your medical expenses from a car accident, the $10,000 is not taxable. In addition, you can exclude any damages for emotional distress as a result of the other party's wrongdoing. For example, if you also receive an additional $5,000 for the emotional distress of the accident, you could exclude that from your income.
Ordinary Income Items
If the damages are intended to replace ordinary income, the damages get taxed at your ordinary income tax rate. For example, if you were unjustly fired from your job and the court awards you backpay of $50,000, intending to replace what you would have made if you worked, that $50,000 is treated as ordinary income. Other examples of ordinary income from lawsuits includes any interest (even if the award would otherwise be nontaxable), punitive damages and damages for patent or copyright infringement.
If the lawsuit represents proceeds that would have been capital gains to you if they had been properly paid, you can treat the income as capital gain income. The distinction matters because long-term capital gains are taxed at a lower rate. As of 2012, the maximum long-term capital gains rate is only 15 percent. For example, if you had a contract to sell an investment and the other party reneged, and the damages you win represent the gain you would have had if the deal went through, those damages would be capital gains.
Deduction for Attorney Fees
If you pay attorney fees in an unlawful discrimination case or for getting an award from the IRS for information you provided about tax violations, you can deduct the fees as an adjustment to income on line 36 of Form 1040. This means you don't have to itemize your deductions. Otherwise, you can only deduct the attorney's fees as a miscellaneous deduction if you are pursuing income that would be included in your gross income or managing, conserving or maintaining property held for producing the income.
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