Are Settlements Earned in Court Taxable by the IRS?

Receiving your long-awaited settlement from a lawsuit is a relief and usually brings wholeness back to your life. It is a very satisfying experience to finally be compensated for wrongs that happened weeks or maybe even months ago. But the question on the minds of many people is, are settlements taxable?

As is the case with any type of tax question, the answer is complex and can be confusing. Whether it is a taxable settlement or not depends on what the money is compensating for from the lawsuit.

The general answer is yes; court settlements are often taxable.

Claim Origin

Deciding on which are taxable settlements and ones that are not is based on the origin of the specific claim, which depends on the reason for the claim that formed the basis for the settlement.

For example, a lawsuit that stems from an injury that took place in an accident could have more than one type of damage claim. Some will result in taxable settlements while others might be tax free.

Depending on the situation, an award for lost wages, wrongful termination, or severance may be taxable as income. If you win compensation for damages to your home that was caused by a negligent builder, instead of taxable income, the IRS may handle that compensation as a reduction in your purchase price of the property.

Court Settlements that are Taxed & Not Taxed

According to the IRS, the money received from a lawsuit must be taxed based on its purpose. Here is how that breaks down for common types of court settlements.

Back Pay: Taxed as Ordinary Income

For example, if you sue for back wages from a W-2 job, that money will usually be taxed as ordinary income. That means you receive a W-2 form for it, and income taxes and FICA taxes will be withheld from your earnings. For the purposes of taxes, your settlement is similar to a typical paycheck.

For instance, it is income that should have been paid to you. So, you can expect to be taxed as if you had received it when you were supposed to.

Personal Injury Settlements

These are actually tax free for “physical” injuries. Proceeds from a personal injury settlement usually will not be taxed at all, however, there are a few exceptions.

How Personal Injury Settlements were Taxed in the Past?

Prior to 1996, all personal damages were tax-free, no matter if they were for physical injuries, emotional injuries, or defamation. The rules have been modified since 1996. Now, just physical injuries and physical sickness are eligible for tax-free damages.

What makes this area complicated is that the tax code does not provide an exact definition of “physical.” However, the IRS has stated that “visible harm” is required.

Emotional Distress Damages & Taxes

An important result of the changes made in 1996 is the following: damages having to do with emotional distress are now taxable. That applies to physical symptoms stemming from emotional distress, such as headaches and stomach aches. Symptoms of emotional distress are not physical.

Unfortunately, it gets murky after that. If your work environment gave you migraine headaches, would your headaches be classified as a physical condition, or would they be considered a symptom of emotional distress caused by your employer?

It is this type of ambiguous area that your attorney will raise and argue on your behalf.

It is helpful to consider the following question when it comes to emotional distress and taxes: Did the physical injury cause emotional distress or did the emotional distress cause the physical symptoms? In short, if the defendant caused your physical injury, it is tax free. However, if emotional distress made you physically sick, that is a taxable settlement.

While emotional distress damages are usually taxable settlements, the amount you have to include in your taxes decreases by:

1. Amounts paid for medical expenses attributed to emotional distress or mental anguish not previously deducted, and
2. Previously deducted medical expenses for such distress and anguish that did not provide a tax benefit.

Settlements for Medical Expenses

These are tax-free. Settlement proceeds will not be taxed if they’re designated for medical expenses. That is the case even if they ultimately are the result of emotional injuries.

Punitive Damages

Punitive damages, which are meant to punish the defendant for outrageous or extremely harmful behavior, can be taxed by the IRS. This is a taxable settlement even if you are awarded punitive damages for physical injuries.

Settlement Interest

Settlement interest is simply interest that accumulates on an unpaid settlement. This is taxable.

You could have both pre-judgment interest, which accrues from the time of the injury to the judgment. There is also post-judgment interest, and that accumulates between the judgment and the time the settlement is actually paid.

Both of these types are taxable for the recipient of these court settlements.