Sure, we’ve heard it before.
Your car got rear-ended at a recent light, your contractor did poor work on your house, and/or you were unfairly fired. These are all realistic situations that may require a settlement agreement. If you’re collecting a settlement or judgment, is it taxable income? Usually yes. However, taxes vary tremendously depending on how you were damaged, how the case was resolved, and even how checks and IRS Forms 1099 were issued.
Eric H. Gordon recommends understanding the following three points regarding legal settlements and taxes… but you should always ask your lawyer about the mentioned matters.
Settlements and judgments are taxed the same. The exact same tax rules apply whether you settle or win a judgment. Nonetheless, you have more flexibility to lower taxes if a case settles. If you are audited, you will be required to present the settlement agreement, complaint, checks, IRS Forms 1099, W-2, etc. You can impact how your recovery is taxed by how you deal with them.
Taxes depend on the “origin of the claim.” Settlements and judgments are taxed based on the origin of your claim. If you’re suing a competing business for loss of profits, a settlement will be lost profits, which is taxed as ordinary income. If you get laid off at work and sue for discrimination seeking wages, you will be taxed on wages. Your old employer will likely withhold income and employment taxes even if you don’t work there anymore.
However, if you sue for damage to your house by a negligent building contractor, your damages generally won’t be income. Instead, the recovery will be treated as a reduction in your purchase price of the condo. These rules have a myriad of exceptions and nuances, so be careful. The biggest exception of all likely applies to recoveries for personal physical injuries.
Recoveries for personal physical injuries and physical sickness are tax-free. If you sue for personal physical injuries, your damages are absolutely tax-free (according to section 104 of the tax code says so). Prior to 1996, all “personal” damages were tax-free, so emotional distress, defamation, etc. also resulted in tax-free recoveries. Since 1996, however, your injury must be “physical.”
The IRS asserts your injuries must be visible. If you sue for intentional infliction of emotional distress, your recovery is taxed. If you sue your employer for sexual harassment (such as rude comments or fondling), that’s not physical enough for the IRS. Taxpayers constantly argue in U.S. Tax Court that their damages are sufficiently physical to be tax-free; the IRS usually wins these cases, but not every time.