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Taxation of lawsuit awards is a complex subject. Taxation of an award depends on whether the plaintiff’s claim involved a physical injury or a non-physical injury. Taxation also depends on whether the purpose of the award was to compensate the plaintiff for his losses or to punish the defendant for egregious transgressions. There are other tax issues associated with lawsuit payouts. The IRS does not distinguish insurance lawsuit awards from other lawsuit awards. It applies the same taxation rules to all lawsuit awards.
The federal tax code excludes from taxes a lawsuit award arising from physical injury or illness claims. The IRS doesn’t collect tax on an award that compensates the plaintiff for medical expenses, lost wages, pain and suffering, and emotional distress suffered because of the physical injury or illness. But if the plaintiff had already deducted his medical expenses from his income taxes, then the portion of the award covering medical expenses becomes taxable.
Lawsuit awards are taxable if they compensate a plaintiff for losses arising from causes other than a physical injury or illness, such as libel, negligence, wrongful firing or breach of contract. But if the non-physical injury led to the plaintiff incurring out-of-pocket medical expenses such as payments to a mental health professional to treat emotional distress, the medical expenses included in the award aren’t taxable unless the plaintiff had already deducted them from her income taxes.
A plaintiff will owe income taxes on lawsuit awards whose purpose is to punish the defendant for recklessness, malice or other reprehensible conduct. There is a narrow exception to this punitive-damage taxation rule when a claim involves wrongful death. If the lawsuit is litigated in a state where state statutes don’t allow compensatory damage awards in wrongful-death cases, then the punitive damage award is exempt from taxation.
Interest associated with any lawsuit award is taxable. There are no exceptions to this rule. The taxable portion of a lawsuit award will increase your total income for the year, which may push you into a higher tax bracket and limit or eliminate income-based exemptions and deductions. If a lawsuit award includes payment of lost wages, the plaintiff will not only owe federal and state income taxes, but also must pay Social Security and Medicare taxes and unemployment taxes on the amount paid. If the payment compensates for lost self-employment income, the payment is subject to federal self-employment tax. Payroll and income taxes are due in the year the settlement is paid, at the tax rates in effect that year.
You can’t subtract the legal fees and court costs of your litigation from the lawsuit proceeds if the lawsuit award is exempt from taxes. But legal fees and court costs are deductible if the award is taxable. If an award is partially taxable, you can deduct a prorated portion of the legal fees and costs based on the ratio of taxable award to total award. Legal fees and court costs are a miscellaneous deduction subject to the normal 2 percent income exclusion.
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