Differentiating taxable and non-taxable lawsuit settlement income is subject to the interpretation of what the tax authorities consider taxable. Moreover, if income from a settlement is not reported, but is taxable, the tax authority is likely to tax you with or without interest and other charges.
Although, we will be limiting our discussion to compensation received in lieu of personal injuries, it would behoove the reader to note that compensation for lost business income is taxable assuming that the income received in the first place was also subject to tax.
Are Lawsuit Settlements Taxed?
A favorable personal injury lawsuit settlement often brings forth a great deal of money as compensation. Personal injury may either be physical or psychological. Settlement for personal injury can be reached without taking the matter to a civil court provided both parties agree.
Settling personal injury lawsuits out of court can be beneficial from the perspective of structuring the payment so as to avoid tax burden. For instance, accepting annuity payments rather than a lump sum amount can help one avoid taxes. This is because annuities are tax-free, structured settlements.
There are times when in-court settlement may be inevitable or preferred. Regardless of whether it is in-court or out of court, the plaintiff may be liable to pay income tax.
Generally, in case of personal injury lawsuits, the attorney works on a contingency basis. In other words, if the settlement is in one's favor, the lawyer is entitled to receive between 33% and 40% of the amount of damages that are awarded through a trial.
Since a significant amount of money that is received in lieu of compensation is lost in attorney fees, this question assumes a great deal of significance.
As mentioned earlier, personal injuries may be physical or psychological. Compensation for personal injury is not taxable provided the plaintiff was physical injured or fell ill as a consequence of wrongful action on the part of the defendant. Moreover, compensation for lost wages on account of physical injury is not subject to tax.
Settlement awarded for mental illness, pain and suffering does not qualify for tax exemption unless emotional distress was due to physical injury inflicted by the defendant. For instance, compensation for emotional distress suffered due to employment discrimination or slander is taxable but settlement for mental stress on account of physical injury is not.
Again, damages received for having sought medical care for physical symptoms, such as headaches, insomnia and stomach disorders, that manifested on account of psychological injury should not be included in taxable income. For a better understanding of tax treatment, one may classify damages as compensatory or punitive.
Punitive damages are awarded to the plaintiff for punishing the defendant provided the former is able to prove that the latter was negligent or committed the offense knowingly, willingly, deliberately or with the intention of defrauding the plaintiff. It's evident that compensation for punitive damages cannot be measured in monetary terms.
Compensatory damages include measurable losses as well as those that cannot be stated in monetary terms. The former refers to actual damages that can be quantified. The latter includes suffering, emotional distress, mental anguish, etc., that cannot be stated in monetary terms. Tax treatment for compensatory damages varies depending upon the situation.
In your best interests, it is advised to take an annuity payment as that would give you a regular source of income and the tax burden would be lesser. Make sure that you do pay the tax on the settlement, if required and considering the complexity of tax treatment, it would be prudent to consult a tax adviser for further details.