Winning money in a settlement can feel like found cash, and being hit by an unexpected tax bill can be a serious disappointment – especially if you were planning on having the extra cash available. To make sure you aren't in for a rude awakening when it comes to determining the potential tax burden of a financial settlement, consult the Internal Revenue Service for guidance. There are many different, sometimes confusing scenarios, in which some types of settlements are taxed, while others are not.
What is a Financial Settlement?
Financial settlements vary in type and amount. You might win a judgment against a person or company in a court of law in which the defendant must pay you cash damages, or settle a case for a certain dollar amount as a way of dismissing a claim. If you are represented by an attorney, the attorney typically collects a percentage of whatever your final settlement amount is as their payment. If your settlement is taxable, you'll only have to pay the amount you actually net at the close of the case.
Elements of Taxation
One of the reasons why the laws surrounding the taxability of settlements are complex is because there are often multiple parts to a settlement. For example, the total amount of your settlement may include a variety of sub-payments, such as lost wages, pain and suffering, medical bill coverage, attorney fees or others associated costs. Some of these items are viewed as taxable income, while others are not.
If you receive a settlement for physical injury or sickness in which another party is at fault, and you didn't take an itemized deduction of medical expenses on your tax return, you won't owe taxes on your settlement amount. However, if you did previously deduct the costs associated with medical care related to the case, those settlement dollars are viewed as taxable income.
Understanding Emotional Injury
Emotional injury is typically treated the same as physical injury when it comes to settlement taxation, provided you were the one suffering the direct trauma. For example, a settlement in which you are compensated for the emotional trauma of having flashbacks about a car accident you were in are non-taxable, while receiving a settlement compensating you for being the witness of a horrific crash you were not physically involved in is considered taxable income. You can deduct from your taxes any medical attention you paid for to combat your trauma, provided it was not previously deducted.
If you receive a settlement that includes reimbursement for lost wages, the proceeds are nearly always taxable, and usually include the standard employment tax withholding you would have had to pay if you received a regular paycheck. If the settlement relates to lost income from a business, the reimbursed amount related to conducting your business is subject to self-employment tax.
Other Settlement Taxation Issues
Cash settlements related to property loss can be complex, but are typically not taxable, provided the settlement amount does not exceed the adjusted basis of your property. Punitive damages are almost always taxable as income, as this type of settlement goes above-and-beyond compensation for physical, property and earning damages. As tax laws are continually changing, and no two settlement cases are the same, consider consulting a trained tax professional if you are unsure of the vagaries of your unique situation and your potential tax burden.