Taxable vs. Nontaxable Settlements: What You Need to Know

Lawsuit settlements can be a complex financial topic, especially when it comes to taxes. Whether you're receiving compensation for a personal injury, breach of contract, or emotional distress, it’s important to understand the tax implications. Here’s a simple breakdown of taxable vs. nontaxable settlements and what to consider when you're awarded a settlement.

Call Turner Business Solutions at (316) 285-0125 if you need assistance to determine if your settlement is taxable. You can also schedule a free consultation online.

What Makes a Settlement Taxable?

In general, the IRS treats settlements like income: if it's money that would have otherwise been taxed, chances are it still is. Here are some common types of taxable settlements:

1. Lost Wages or Profits: If you’re awarded a settlement for lost wages or business profits, this money is taxable as income. For example, if you win a lawsuit for wrongful termination or breach of contract, any compensation replacing your paycheck or business revenue must be reported on your taxes.

   
   

2. Punitive Damages: These are meant to punish the defendant for egregious behavior rather than to compensate you for losses. Since punitive damages don’t serve to reimburse you for an injury or financial loss, the IRS considers them fully taxable.

   
   

3. Interest on Settlements: Sometimes, settlements include interest, especially if there’s been a delay in payment. Any interest portion of the settlement is always taxable, regardless of the nature of the lawsuit.

   
   

4. Non-Physical Emotional Distress: Settlements for emotional distress or mental anguish that are not tied to a physical injury are taxable. For example, if you're compensated for workplace harassment that caused you stress but no physical injury, the settlement may be subject to tax.

   
   

5. Attorney Fees: Depending on how your settlement is structured, the portion that goes toward paying your attorney may also be taxable. In some cases, the IRS treats this amount as part of your taxable income.

   
   

What Settlements Are Nontaxable?

On the flip side, some settlements are not subject to taxation. These typically revolve around compensation for personal injuries or medical expenses. Here are the key examples:

1. Physical Injury or Sickness: Settlements awarded for personal injuries or sickness are generally nontaxable. For instance, if you’re involved in a car accident and receive compensation for physical injuries, pain and suffering, or medical bills, that money is typically tax-free. The key here is that the injury must be physical.

   
   

2. Medical Expenses: If your settlement reimburses you for out-of-pocket medical expenses related to a physical injury or sickness, the amount is also nontaxable—as long as you didn't previously deduct those expenses on your tax return. If you did claim a tax deduction, you may need to pay taxes on the reimbursed amount.

   
   

3. Workers' Compensation: Settlements for work-related injuries, covered under workers' compensation laws, are almost always nontaxable. Whether you receive a lump sum or ongoing payments, this type of compensation is generally tax-exempt.

   
   

4. Emotional Distress from Physical Injury: If you experience emotional distress due to a physical injury (like anxiety following a car accident), the settlement for that emotional distress is usually nontaxable. The physical injury must be the root cause of the emotional distress for it to qualify.

   
   

Mixed Settlements and Allocations

In many cases, settlements can be a mix of taxable and nontaxable components. For example, a settlement might include compensation for lost wages (taxable), as well as pain and suffering from a physical injury (nontaxable). In such cases, it’s important that your settlement clearly allocates different amounts to different claims. Proper allocation can help you avoid overpaying taxes.

Consult a Tax Professional

Since settlement taxation can get complicated, especially when multiple components are involved, it’s a good idea to consult a tax professional. They can help you accurately report your settlement on your tax return and avoid any potential issues with the IRS.

Key Takeaways:

• Settlements for lost wages, punitive damages, and non-physical emotional distress are generally taxable.

  
  

• Settlements for physical injuries, medical expenses, and workers' compensation are usually nontaxable.

  
  

• Interest on settlements and attorney fees may also be taxable.

  
  

• Clear allocation of settlement amounts can help minimize tax liability.

  
  

Understanding the difference between taxable and nontaxable settlements will help you navigate the tax implications of your legal victory. Always seek professional advice to ensure you're in compliance with IRS rules and to maximize your financial outcome.

Call Turner Business Solutions at (316) 285-0125 if you need assistance with your taxes. You can also schedule a free consultation online.