If you are a plaintiff, you can obtain proceeds from a lawsuit in two ways -- through a judgment or through a settlement. Either way, the Internal Revenue Service, and perhaps your state government, may take a share of the money. Whether or not your lawsuit proceeds are taxable depends on what they are designed to compensate you for.
Amounts awarded to you to compensate you for personal injury, meaning physical injury or sickness, are not included in your gross income, meaning you don't have to pay taxes on them. If you are awarded damages for pain and suffering due to a personal injury, you can exclude this amount from your taxable income as well. You can't exclude punitive damages from your taxable income, however, even if they arose from a personal injury.
Amounts awarded for non-physical injuries are taxed at ordinary income tax rates. Such amounts include emotional distress that doesn't arise from personal injury, damage to your reputation (defamation), racial discrimination, wrongful discharge, lost wages and lost business profits.
Amounts awarded to compensate you for property damage are tax-free to the extent that they don't exceed the value of your investment in the property -- your property's "adjusted basis" in IRS terminology. The adjusted basis of your property equals the amount you originally paid for it, plus or minus any adjustments. You might have to subtract from your property's basis for depreciation, for example, or add to it if you spent money improving it. Any amount by which your lawsuit proceeds exceed your property's adjusted basis is taxed under complex capital gains tax rules. This might mean that you will be taxed at favorable capital gains tax rates.
If you were compensated for business losses, you can write off your attorney's fees as a business expense. If you were compensated for a personal injury or a non-physical injury, you can write off your attorney's fees as a miscellaneous itemized deduction, but you may end up having to pay alternative minimum tax. If you were compensated for racial discrimination, however, you can write off your attorney's fees as an "above the line" deduction that won't trigger alternative minimum tax.
States tax lawsuit proceeds in different ways. In New York, for example, you can write off compensation for both personal injury and pain and suffering, except in certain wrongful death cases. Of course, you won't have to pay state taxes on lawsuit proceeds if your state doesn't impose an income tax in the first place.
Although the taxation of settlement proceeds is based on the reason why the proceeds were awarded, you can't avoid taxation by simply insisting that your settlement agreement be worded so as to minimize your tax burden. If, for example, your settlement agreement mischaracterizes compensation for emotional distress as compensation for medical expenses, the IRS may investigate the true reasons for your compensation and tax you accordingly.
You may save money on taxes by insisting that the defendant pay a settlement in annual installments rather than in lump sum, so as to keep the proceeds from putting you into the highest tax bracket. Of course, if your settlement is large enough, there may be no way to avoid the highest tax bracket.
- Internal Revenue Service: Settlements -- Taxability
- FIndLaw: Uncle Sam and Settlement Proceeds: Is the Settlement Taxable?
- Ziff Law Firm: Taxes and Your Personal Injury Settlement – What You Need to Know
- Forbes: Don't Fail To Consider Taxes When Settling Litigation
- Weitz & Luxenberg: Lawsuit Awards and Settlements: IRS Tax Law
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