The purpose of most lawsuits is to make a plaintiff whole after an injury or other loss. Settling a lawsuit might bring the litigation to a close, but the plaintiff must still contend with the IRS. Luckily, taxation of lawsuit settlements is fairly straightforward once one understands a few principles that our Los Angeles tax advisors can explain.
Settling a Lawsuit vs. Winning a Verdict or Judgment
The IRS makes no distinction between a payment received due to a settlement and one that comes after a jury verdict or court order. In either case, a taxpayer receives compensation for one or more legal claims. We will use the term “settlement” for the sake of brevity, but the same principles apply to damage awards.
One advantage of a verdict or court order is that it is more likely to contain a breakdown of damages. Verdicts often specify the amounts awarded for different claims. This can help a plaintiff when they are preparing their taxes. For this reason, it is often advisable to include a written allocation of damages in a settlement agreement.
“Origin of the Claim” Rule
Whether a settlement amount is subject to federal tax depends on the underlying purpose of the plaintiff’s claim. If a lawsuit claims back pay after a wrongful termination, for example, the settlement is taxable as wage income. A settlement in a breach-of-contract lawsuit seeking damages for lost profits would be taxable as business income.
Personal Injury Lawsuits
Lawsuits based on injuries sustained in accidents often involve multiple different damage claims. Some of these are taxable, while others are not.
Physical Injuries and Illnesses
The Internal Revenue Code excludes damages for “personal physical injuries or physical sickness” from its definition of “gross income.” Amounts received in a settlement that compensate a plaintiff for what the IRS calls “observable bodily harm” are therefore not subject to federal income tax.
Settlement funds that directly compensate a person for medical expenses are not taxable as income to the extent that those medical expenses are tax-deductible. If the plaintiff has already claimed the medical expenses as a deduction, however, the settlement is taxable.
Personal injury lawsuits often claim damages for “emotional distress,” meaning harm that extends beyond a plaintiff’s physical injuries. These are often referred to as “non-economic damages.”
Since these are not “physical” injuries, they are not excluded from taxable income, with one potential exception. If a plaintiff has received medical care for their non-physical injuries, such as counseling, the portion of a settlement that compensates them for those expenses might not be taxable as income.
Compensation for lost wages, such as time missed from work due to injuries, directly replaces a plaintiff’s work-related income. It is therefore taxable as income.
Settlements in other types of lawsuits are generally considered to be taxable income. This could include damages for breach of contract, intellectual property infringement, or violations of employment statutes. Punitive damages are treated as taxable income in most situations, including personal injury lawsuits.
Different types of damages could be subject to different types of tax. This depends on the nature of the claim. A settlement providing back pay is taxable as ordinary income. A settlement that compensates a plaintiff for loss in value of their property might be subject to capital gains tax.
If you need assistance with finding a solution for a tax issue in California, the Enterprise Consultants Group’s tax advisors are available to answer your questions and discuss your rights and options. Please contact us today online or at (800) 575-9284 to schedule a consultation with a member of our team.