Going to court can be expensive, so plaintiffs and defendants in civil trials often enter into negotiations and arrive at settlement agreements to avoid lengthy court trials. If you receive damages under such a settlement, the cash may or may not be considered a form of taxable income. Whether you will owe tax on the amount of a settlement depends on the specific details of each case and the reason for the settlement.
Physical Injury and Illness
A settlement related to a personal physical injury or illness you suffered is generally not a form of taxable income, so you don't include it on your federal tax return. An exception arises in the case of tax-deductible medical expenses. If you receive a settlement for medical expenses that you have previously deducted on your tax return, you must include in your taxable income that portion of the settlement you received for those expenses.
Lawsuits sometimes involve awards for emotional distress caused by a traumatic event. According to the Internal Revenue Service, cash you receive for emotional distress or mental anguish originating from a personal physical injury or physical illness is treated the same as money you receive for the physical injury or illness itself; in other words, it is not taxable. Any settlement you receive for emotional distress or mental anguish that is not associated with a physical injury or illness, however, is taxable income. You can reduce the taxable amount by any medical expenses attributable to the emotional distress you suffered.
A lawsuit related to your job or business can result in a settlement for lost wages or profits. If you receive a legal settlement as a result of an employment-related lawsuit, such as for unlawful employment discrimination, any proceeds that are for lost wages is taxed as ordinary income and is also subject to Social Security and Medicare taxes. Any amount of a settlement you receive for lost profits of a trade or business is considered business earnings so it is taxed the same as other business profits and subject to self-employment tax.
If a lawsuit goes to a court decision, the court could award punitive damages, which a defendant has to pay above any actual damages it caused as a punishment for wrongdoing. Punitive damages are always treated like taxable income, even when received in a settlement for personal physical injuries or illness.
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