Is Settlement Money Taxable?

Lawsuits take a big toll on those involved, but the process is worth it when you receive settlement money. Whether you’ll have to pay lawsuit settlement taxes depends on the nature of the lawsuit.

Taxes on Settlement Proceeds

If your lawsuit concerned personal injury, you’re in luck in one sense. A personal injury lawsuit often deals with serious and possibly permanent injuries, but a personal injury settlement isn’t taxable. Lawsuit money from other types of claims is taxable as ordinary income. That’s a problem, as the money itself will likely propel you into a higher income tax bracket for the year in which you receive the settlement. However, if the settlement is paid in installments rather than a lump sum, that may make the tax bite easier.

When a Personal Injury Settlement is Taxable

While compensatory damages from a personal injury lawsuit are not taxed, that’s not the case if the jury awards punitive damages. Compensatory damages include lost wages and medical expenses, but do not include awards for emotional distress unless it is caused by the injury or illness. Many times, emotional distress in personal injury cases isn’t a direct result of the injury, but the circumstances, and those do not count. You will have to pay taxes on the interest received from personal injury settlement money. Report such interest on 2017 Form 1040, line 8a.

Punitive damages are awarded when the defendant acted in such a negligent or reckless manner to cause the accident that the jury wants to punish them financially. If you receive $250,000 in compensatory damages for your personal injury but $1 million in punitive damages, you must pay taxes on the latter. That will undoubtedly propel you into the top tax bracket for the year, which is 37 percent for 2018 and 39.6 percent for 2017.

Other Types of Lawsuits

Expect to pay taxes on any other type of lawsuit money, whether it involves employment, breach of contract, libel, torts and other claims not involving personal injury. Report your lawsuit money on Form 1040, line 21, which involves other income.

Attorney Fee Deduction

For taxable damages, the IRS permits you to deduct attorney fees for tax years 2017 and prior. In personal lawsuits, deduct the fees as a miscellaneous itemized deduction on Form 1040, Schedule A. If the lawsuit pertains to a business, attorney fees are treated as a business deduction. Say you receive that $ 1 million as punitive damages, and per your agreement the attorney receives 40 percent of that amount, or $400,000. You must claim the entire $1 million on your income tax return, but then deduct the $400,000 as a miscellaneous itemized deduction. There are exceptions. For example, if a union files claims against a company on behalf of its members and obtains a settlement including attorney fee payment, those union members don’t need to report the attorney fee payment as taxable income, according to the American Bar Association.

2018 Tax Changes

Starting tax year 2018, the miscellaneous itemized deductions have been eliminated. Taxpayers will no longer be able to deduct their attorney fees. There's also a newly designed 1040, which utilizes a series of schedules to report income and expenses.