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If you settle a lawsuit in your favor, you will probably have to deduct attorney's fees from any amount you receive. In addition, you may have to pay state and federal taxes. Whether you have to pay taxes on all or part of your settlement depends on what the money compensates you for, and how you receive the money.
Under U.S. tax law, you must report all of your income to the IRS unless there is a law that specifically excludes a portion of it from your gross income. Since compensation for certain types of damages are excluded from gross income under U.S. tax law, the taxability of your settlement depends whether your compensation falls within an exclusion.
One of the gross income exclusions available under the Internal Revenue Code applies to compensation for physical injury and sickness. Damages for emotional distress are taxable, however, except to the extent that they compensate you for medical expenses arising from observable injuries or sickness resulting from your emotional distress, such as medical bills relating to a suicide attempt. If you claimed the medical expense deduction for any of these expenses, however, you must include your settlement award in your gross income.
Compensation for non-physical injuries that do not result in physical injuries or medical bills -- such as for emotional distress, lost wages, lost business income, defamation, wrongful discharge or racial discrimination -- are taxable as ordinary income.
Settlement awards that compensate you for property loss can be excluded if they do not exceed your adjusted basis in the property. Your basis in property is the amount that you paid to acquire it -- for real estate, for example, it might be the amount you paid for the property, plus real estate broker's fees. Your adjusted basis represents any change in your basis over time -- depreciation, for example, or the value of improvements that you added. If the amount of your compensation exceeds your adjusted basis in the property, you are taxed at capital gains tax rates on the amount by which your compensation exceeded the adjusted basis in the property.
If your settlement represents compensation for a business loss, you can write off your attorney's fees as a business expense. If your settlement is compensation for some type of physical or non-physical personal injury, however, amounts taken from your settlement to pay your attorney are treated as your income, even if the money never passed through your hands. Although you may still deduct attorney's fees as a miscellaneous itemized deduction, the alternative minimum tax might apply, leaving you with a tax bill for money that went to your attorney. Compensation for discrimination is an exception, however -- it is treated as an "above-the-line" deduction rather than an itemized deduction, and therefore won't trigger alternative minimum tax.
Different states tax settlement awards in different ways. In New York and Pennsylvania, for example, personal compensation for both injuries and pain and suffering are tax-free, except in a wrongful death case. Settlement awards for lost wages, on the other hand, are taxable. In the state of Washington, which imposes and business and occupation tax but not an income tax, settlement awards for personal injuries and non-merchandise property damage are tax-free.
If you receive your settlement in lump sum, you will have to report all of the taxable amount during the same tax year. If this amount is large, you might be forced into the highest tax bracket. If you trust the long-term solvency of the defendant, take partial payments over several years.
- 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.com: Don't Fail To Consider Taxes When Settling Litigation
- Internal Revenue Service: Settlements -- Taxability
- Washington State Department of Revenue: Are Legal Settlements Taxable?
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