If you settle a lawsuit and receive compensation for damages, you may have to pay income tax on some or all of the money you receive. Certain types of payments are excluded from lawsuit settlements tax, which makes the situation complicated. The decision about whether a particular payment is taxable is determined by the reason for the payment and the claims you made in previous tax years.
Depending on the circumstances, certain civil lawsuit settlements are taxable, while others are exempt.
Your Responsibility to Report Income
Under U.S. tax law, you must report all of your income to the Internal Revenue Service, unless there is a law that specifically excludes a portion of it from your gross income. Since compensation for certain types of damages is excluded from gross income, the question of whether you need to pay state and federal tax depends on whether any exemptions apply.
If the funds are received to settle an employment-related legal action, any money paid to reimburse you for lost wages is taxable. These monies are subject to withholding tax by the employer. You would report these earnings on Line 7 of the 2017 Form 1040. Interest paid to you on any settlement funds is usually considered taxable. You would include it on Line 8a of Form 1040. If you received punitive damages as part the settlement of your legal claim, these are also taxable. This money would be reported on Line 21 of Form 1040.
IRS Lawsuit Tax Exemptions
One of the gross income exclusions available under the tax code applies to compensation for physical injury and sickness. If you didn't add up your medical expenses and take an itemized deduction for them before your case was settled or decided in court, the entire amount you received as compensation for physical pain and medical expenses is not taxable.
If you have previously claimed medical expenses related to injuries or sickness related to your lawsuit, the rules are different. You must include the amount you previously claimed for these medical expenses as income if they provided you with a tax benefit. In a situation where you claimed medical expenses for more than one year, you will need to account for the tax benefits you received for these years on a proportional basis. This income should be reported on Line 21 of Form 1040.
Monetary damages you received for mental anguish or emotional injuries stemming from physical injuries or illness you suffered are treated the same way as money you receive as compensation for physical injuries. These funds come to you on a tax-free basis.
If you receive compensation for emotional injuries that are not related to physical injuries or a physical sickness, you must report this money as part of your income. You'll need to reduce this figure by any amount you have already paid for medical expenses for emotional injuries which have not been previously deducted. Subtract any medical expenses that have been deducted on your income tax returns that didn't provide you with a tax benefit.
Lawsuit Settlements Tax 2018
The tax code has been revised for 2018 and a newly designed 1040 has been issued. Settlements received from the government, government departments or nongovernment entities "that exercise self-regulatory powers" are generally not deductible. This rule doesn't apply to private claims, though.
There is an exception to the rule stating that settlement funds received from the government are not tax deductible for 2018, if the settlement funds are being paid as restitution for damages caused by "a violation of the law." These funds must be identified in this manner in a settlement agreement or court order to be tax deductible.
Settlement monies received for sexual harassment or sexual abuse lawsuits are not tax deductible if the settlement is subject to a nondisclosure agreement. Due to the elimination of miscellaneous itemized deductions for tax years 2018 through 2025, attorney's fees are no longer deductible.
Lawsuit Settlements Tax 2017
Under 2017 tax rules, certain benefits are not considered taxable. Damages paid for physical illness or physical sickness, whether you receive them in a lump-sum payment or as periodic payments, are not taxable. Benefits paid out under a health or accident insurance policy where you or your employer paid the premiums, and you had to include the premiums as income, are not taxable. Disability payments received under a no-fault auto insurance policy for lost income are also in this category. If you receive a payment for lost bodily function, this payment is not taxable.
Payments made to reimburse you for money paid out for medical care are also not taxable. Keep in mind that these payments may reduce the amount you can claim for your medical expense deduction.
Since lawsuit settlement tax matters can be complicated, consult with an income tax professional if you have questions or concerns about your personal tax situation.
Jodee Redmond is a freelance writer, blogger and editor who has been working full-time in this capacity for over 15 years. She is a graduate of Centennial College and has worked as a tax consultant and a legal assistant. Her previous experience and boundless curiosity is a distinct advantage when writing about such varied topics as income tax, insurance, commercial property, business, construction, addiction, freelance writing and more.