Although the Internal Revenue Service considers most money you receive as taxable income, some settlement monies are exempt. However, even if the settlement itself is exempt from income tax, portions of it can be taxable. Knowing what is and is not taxable is imperative to prevent penalties if the IRS selects your return for an audit. Talk to your accountant or tax preparer if you have questions about nontaxable income.
Personal Injury Settlements
Typically, settlement awards for physical sickness or injuries are not taxable. However, if you itemized your return and deducted medical expenses associated with the injury or sickness before you received your settlement, you must pay taxes on at least part of your settlement. For example, say Bob suffered an injury in an accident two years ago then itemized his return and deducted $20,000 that he paid for doctor bills from the accident. If Bob then receives a $100,000 settlement award, $80,000 of the amount is tax-free but he must pay taxes on the $20,000 medical bill reimbursement.
Any amount you receive for mental anguish or emotional distress is taxable, except portions used to pay medical costs that you did not deduct on a previous return. Awards for lost profits or wages are nontaxable so long as the loss stemmed from a personal injury or sickness. However, if you sued your employer for discrimination and won an award for lost wages, it is taxable. If you receive a settlement arising from a loss of property, any amount you receive that is more than the value of your property is taxable.
Interest and Fees
If you receive interest with your settlement, you must pay taxes on the interest. For example, if your $100,000 award includes $2,822 for interest, the $2,822 is taxable as ordinary income. You cannot subtract the fees you pay to your attorney from your settlement or, if the settlement is nontaxable, deduct the fees from your taxes. If part of your settlement is taxable, calculate the percentage of the taxable amount to determine how much of the fee you can include in your itemized deductions. For example, if $20,000 of your $100,000 settlement is taxable income, multiply your attorney's fee by .20 to determine your deduction.
How to Report
Report all taxable settlement income on line 21 of Form 1040 unless the settlement is for a property loss. If you receive more than your property's value, you must report the excess using Schedule D for Form 1040. If your business received a property settlement, report the excess using Form 4797 as if the settlement was for the sale of the property.
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