To comprehend the income tax ramifications of settlements, one must first evaluate the appropriate regulatory framework. Internal Revenue Code (IRC) 61 provides a wide interpretation, saying that gross income includes “revenue from whatever source generated,” unless specifically excluded. A limited exclusion exists under IRC 104 in the context of funds paid pursuant to certain personal injury claim resolutions. It is vital to note that the exclusion applies only to losses other than punitive damages acquired “as a result of a personal physical injury or physical disease.”
The main rule of taxability for money earned via litigation settlements and other legal remedies is the Internal Revenue Code (IRC) Part 61, which provides that all income, regardless of source, is taxable if not exempted by another section of the code. Section 104 of the Internal Revenue Code exempts litigation, settlements, and awards from taxable income. Nevertheless, the facts & circumstances surrounding each settlement payment must be evaluated in order to identify the reason for which the money was obtained, because not all settlement payments are tax-free. The fundamental question is, “What was the settlement (and its associated payments) meant to replace?”
What Are the Various Types of Lawsuit Settlements?
If you get a settlement as a result of a lawsuit, it might be for one of several reasons. You might obtain compensation for bodily harm, compensation for a non-physical injury, or punitive damages as a result of the defendant’s actions. Even if you regularly pay your taxes online, it may be a good idea to engage a tax accountant during the tax year in which you get your settlement. The IRS regulations governing which components of a lawsuit settlement are taxable might be complex.
How Do Lawsuit Settlement Taxes Work?
The tax liability of those who receive litigation settlements is determined by the type of settlement. Damages from a bodily injury, in general, are not taxable income. However, if you’ve previously deducted expenditures related to your injury, such as medical bills, your damages will be taxed. The same tax benefit cannot be obtained more than once.
In certain rare situations, you may be able to recover compensation for physical harm caused by a non-physical claim.
For example, if you win a libel claim and receive compensation for the physicians you consulted about your stress-related headaches after being libelled, the compensation for those medical expenditures is not taxable, providing you haven’t previously deducted them from your taxes. Although emotional distress damages are normally taxable, there is an exemption if the emotional distress is caused by physical harm or shows as medical symptoms for which you seek treatment.
Punitive damages, as well as back pay & interest on unpaid money, are usually taxed. Damages for emotional anguish are similarly taxed, subject to the restrictions listed above. And here’s the kicker: you must pay taxes on the whole sum received, including any attorney expenses. That’s accurate – even if you don’t take the money home, it’s still considered part of your prize and is taxed. If the opposing party is required to pay your attorney’s fee, that money is also taxable income. You are allowed to deduct your legal expenses depending on the sort of litigation you bring.
You will need the assistance of a tax accountant or a tax lawyer to manage the post-settlement procedure and stay on the right side of the law. However, you don’t have to be an expert to see that it’s a good idea to set away a portion of your settlement to meet the tax obligation. Receiving a settlement might push you into a higher tax band, resulting in a significantly larger April payment than normal.
