The Internal Revenue Service doesn’t care if you settle a lawsuit or go to trial to let a judge or jury decide the case. The money you recover -- called damages in the legal profession -- is treated the same for tax purposes. This isn’t to say that one firm rule applies to all lawsuit proceeds, however. Whether you’ll have to pay taxes on the money depends on how the money is awarded.
“Physical” is the magic word when it comes to lawsuit settlement proceeds and taxation. If you’re physically hurt and your injury led to the lawsuit, compensation you recover is generally not taxable. This is the case at both state and federal levels, and the rule covers not just injury but illness -- say, if you become sick due to someone’s negligence. There’s one catch, however. If you had to pay for medical care and your settlement proceeds include compensation for this, you must pay taxes on any portion that you deducted from taxes in previous years.
Emotional Pain and Suffering
"Physical" is still the pivotal word when it comes to damages for emotional issues. If your pain and suffering is the result of injury or illness that gave rise to your lawsuit, the damages aren’t taxable. If your lawsuit relates to something other than personal injury, such as discrimination, defamation or an employment issue, the IRS will tax you on the money at the percentage rate determined by the tax bracket you fall into when adding in your other income. You’ll also have to pay Social Security and Medicare taxes on the damages. If you’re negotiating a settlement with the party you’ve sued, talk to your lawyer before you sign an agreement if your case involves both physical and nonphysical claims. You’ll want to make sure that if your pain and suffering is related to physical injuries or illness, this is clearly stated.
Damages or proceeds in a lawsuit fall into one of two categories: compensatory and punitive. Compensatory damages make you whole again for a loss you suffered, such as reimbursing your medical expenses or compensating you for pain you suffered. Punitive damages are intended as punishment to the party who wronged you. If your pain and suffering damages are punitive, or if it’s not clear from your settlement agreement whether they’re punitive or compensatory, you may have to pay taxes on the money. Your agreement should clearly spell out what type of damages your settlement money represents.
Interest on Damages
Lawsuits -- and negotiating a settlement to avoid court -- can take a lot of time, even years. In many states, if you win the lawsuit and recover money, interest is tacked on beginning at the time you filed your lawsuit and ending when you actually receive the money. If interest is added, this portion of the proceeds is subject to taxation.
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