Is My Settlement from a Lawsuit Taxable?
Discussion of proceeds from a settlement and medical expenses paid . . .
Proceeds received in a lawsuit can have many different tax implications. Often this depends on the nature of the lawsuit and the reason for the settlement payments, but it can also depend on how past events were treated. This article will touch on some of the more typical situations that occur when a taxpayer receives funds from settling a lawsuit.
If you have ever been injured in an accident, or known someone who has, it's a brutal experience. Not only is there the trauma of the physical injury to deal with, but the aftermath is almost as bad. The last thing an injured person wants to do is to think about a lawsuit - they just want and need to focus on their injuries and healing. The reality, however, is that the injured - and their family - have to consider if their injuries might warrant a personal injury claim. There is also the challenge of hiring a personal injury attorney - there are great PI attorneys out there, but a personal injury will tend to draw out every sketchy attorney who relishes the opportunity to lock in 30% of the settlement proceeds as their fee.
Settling a personal injury case can take years in some instances. Fortunately, there is a little bit of compassion in the Internal Revenue Code that provides that proceeds received in a settlement that relate to personal injury or physical sickness are nontaxable. This is also extended to include proceeds that are received for mental anguish or emotional distress, as long as the amount of the proceeds received for mental anguish or emotional distress resulted from a physical injury or sickness. There is a caveat, however: If a taxpayer previously took itemized deductions for any medical expenses related to those injuries, the proceeds received from the settlement are taxable up to the amount of the deduction that was previously taken.
This can get murky in many cases. For instance, what happens when a settlement is received for personal injury (nontaxable in the year of receipt), and medical expenses are incurred many, many years later, but those expenses are clearly related to the underlying injuries that were incurred by the taxpayer?
Aside from personal injury, if the proceeds received were related to employment, as in the case of unlawful discrimination or involuntary termination, the amount that relates to lost wages is taxable, and is also subject to the normal withholdings for wages (federal and state income tax, as well as social security taxes). Similarly, if one is self-employed, the proceeds received for lost profits from a trade or business are also subject to income tax as well as self-employment tax.
Proceeds received for the loss in value of property are treated differently. Generally, if proceeds received are less than or equal to the adjusted basis in the property (the adjusted basis is usually the purchase price less any allowable depreciation), the proceeds are nontaxable. However, any amount received in excess of the adjusted basis would be taxable gain, and likely reportable as a capital gain on Schedule D or as ordinary income on form 4797.
Note that all interest income received as part of a settlement is taxable income. Proceeds received for punitive damages are also taxable to the recipient. Bear in mind that, if taxable, recipients of these funds could be subject to the need to pay estimated taxes on a quarterly basis (federal and state), or be subject to penalties.
Not only are there physical issues to deal with, legal matters to consider and contend, there are clearly tax matters to negotiate as well. This area can be complicated and each case can be unique. As usual, we suggest talking to a CPA who is qualified and experienced when encountering situations like this.
