When are Legal Settlements Taxable?

Posted on September 6 2011 by admin

According to the IRS, “all income is taxable from whatever source derived, unless exempted by another section of the Code” (IRC Section 61).  How does that affect monetary awards in legal settlements?  Awards and settlements can be broken into two separate groups to determine whether they are taxable or not.  The first includes claims relating to physical injuries, and the second is for claims which are related to non-physical injuries.

Within these two groups, the claims typically fall into three categories:

1.  Actual damages resulting from the physical or non-physical injury
2.  Emotional distress damages arising from the actual physical or non-physical injury
3.  Punitive damages

Typically settlements related to physical injuries are non-taxable.  This includes awards for compensatory damages, including lost wages received as a result of the physical injury.  In addition, medical expenses not previously deducted, pain and suffering, and the lost wages received as a result of the accident are excludable from income. 

Also excludable from taxable income are emotional damages awarded which are related to the physical injury/sickness.  With this award various facts must be considered, such as:  medical bills for mental disturbances, psychological treatment or counseling, lost workdays, documentation for medications and antidepressants, the ability of the individual to care for his/her family, sick leave taken, etc.  The facts and circumstances of the situation for emotional awards must be reasonable and related to the physical injury.  Usually, these are the only situations in which monetary awards are non-taxable. 

Punitive damages are taxable, even when awarded in a personal injury claim—with one exception.  The exception applies to damages awarded for wrongful death, where under state law (Alabama), punitive damages are the only damages that may be awarded. 

Care should be taken where settlements must be allocated between taxable and non-taxable compensation.  For example, a settlement award may include punitive damages in addition to compensation for the personal injury.  Compensation for the personal injury would be excludable, while the portion allocable to punitive damages would be taxable.

In cases where there is no physical injury or sickness involved, such as wrongful employment discharge, employment related, discrimination, libel (defemation of character), etc., awards are typically taxable.  Damages received related to economic loss, lost wages/income, and benefits are also all taxable.  On the other hand, the portion of such an award for reimbursement of out-of-pocket medical costs related to emotional distress are not taxable as long as they fall within the medical expense parameters outlined by the IRS.

Each case is different, and has its own set of facts and circumstances.  When receiving a legal settlement, be sure to consult with your tax advisor to determine the taxable and non-taxable portions of the awarded settlement.

Yvonne Michelle, MBA

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