If you receive a lawsuit settlement, you can expect forms related to it to start rolling in at tax time. Depending on the type and complexity of your lawsuit, you may get several different settlement reports from multiple sources, and things can get confusing in a hurry. Today we’re happy to give you an overview of legal settlement taxation and help demystify the related tax issues, but note that this is a very complicated area of tax law. We strongly advise you to consult with a CPA when reporting income from a lawsuit on your taxes.

If you receive a lawsuit settlement, you can expect forms related to it to start rolling in at tax time. Depending on the type and complexity of your lawsuit, you may get several different settlement reports from multiple sources, and things can get confusing in a hurry. Today we’re happy to give you an overview of legal settlement taxation and help demystify the related tax issues, but note that this is a very complicated area of tax law. We strongly advise you to consult with a CPA when reporting income from a lawsuit on your taxes.

Do you Have to Pay Taxes on a Lawsuit Settlement?

If you read our blog regularly, you probably already know the answer to this question: It depends. The intricacies of the tax law mean it is a rare occasion that we can answer a question with a simple yes or no, and lawsuit settlements are no different.

Generally speaking, a lawsuit settlement isn’t taxable if it covers your medical expenses or property damage. Put another way, compensatory damages are often tax-free. Punitive damages are always taxable, however, as are recovered wages and interest payments. There are, however, exceptions to almost everything we just said, so don’t stop reading quite yet.

Physical Injuries and Sickness vs Emotional Distress

The tax treatment of settlements received for sickness or injury depends on how you handled your medical expenses. If you did not deduct any medical expenses related to your physical injury on previous tax returns, the settlement money you receive is not taxable. The IRS won’t allow you to double-dip, however. If you deducted medical expenses related to your sickness or injury during a previous year, part of your settlement is taxable.

Here is an example.

Let’s say you were injured in a car accident in 2020. As a result of the accident, you required a surgery that cost $30,000. You paid the hospital bill in 2020 and deducted the $30,000 from your income taxes as a medical expense. In 2021, the lawsuit related to your accident was settled, and you received $50,000 for your physical injuries to cover both past and potential future medical expenses. In this case, $30,000 of your settlement is taxable and $20,000 isn’t.

Emotional distress claims also add another wrinkle to your taxes. Emotional distress settlements related to your physical injures aren’t taxable. Let’s return to our car accident example. In this scenario, you were unable to work for several months after your accident and subsequent surgery and were also unable to attend your daughter’s wedding. This resulted in severe depression and emotional distress. In this case, your emotional distress settlement isn’t taxable because the distress was the direct result of your injuries.

The money you receive for emotional distress alone, however, is taxable. Pretend, for example, you get in a fight with a coworker. In his anger, he starts to spread malicious rumors about you and your work performance, and these rumors negatively and substantially impact your reputation and ability to retain clients. As such, you sue home for slander. You also sue for emotional distress as the negative impact on your career has caused great stress in your life. Perhaps you’ve even needed to seek treatment for severe tension headaches as a result. In this case, any money awarded to you for emotional distress is taxable because the distress was not caused by a physical injury.

Punitive Damages and Interest

The compensation you receive for punitive damages is always taxable income. So what are punitive damages exactly? Punitive damages are monies the judge awards you in order to punish the party who caused you injury. Again, an example is helpful. Let’s return to our previous car accident example.

After your car accident, it’s discovered that the person who hit you was driving under the influence. The judge will order the drunk driver to pay for your medical bills, but he may not feel this is enough. To further punish the other driver for negligently driving drunk, the judge may award you an additional $20,000 in punitive damages. This money is taxable to you.

Any interest you receive on legal settlements is also taxable. When applicable, interest generally accrues between the time of your judgment and the time you receive the money.

Lost Wages or Lost Profits

Lost wages and lost profit essentially refer to the same thing. Lost wages are meant to compensate you for any wages you lost due to another’s negligence. This money is lost wages when you work for a traditional employer and lost profits if you work for yourself.

Wages and business profits are both taxable income, and lawsuit settlements don’t change this fact. As such, settlement money you receive for both lost wages and lost profits are taxable income. The IRS will charge you income taxes on both and require you to pay self-employment taxes on any recovered profits.

Loss-in-Value of Property

This one gets a little tricky. Whether or not you pay tax on a settlement resulting from a loss of property value depends on the amount of the settlement as compared to your basis in the property. If the settlement is worth less than the property, the settlement isn’t taxable but it reduces your cost basis. If the settlement is worth more than the property, you must pay tax on the excess.

Let’s say you buy a condo for $300,000 on beachfront property. Your condo association owns your building and the empty property in front of it. You buy the condo only under the condition that the owners of that property agree never to develop it. But they do, and now your view of the beach and ocean is blocked by another condominium building, thus reducing the value of your condo. You sue, and the judge agrees with you.

If the judge awards you a $100,000 settlement, it’s not taxable to you because it’s less than your $300,000 basis in the condo. You pay no tax on the money, but you do have to adjust your cost basis on the condo. Before, if you sold your condo for $400,000, you would have a profit of $100,000. (The $400,000 you sold it for minus the $300,000 you paid.) If you sell your condo after the judgment, however, your profit is $200,000. (The $400,000 you sold it for minus your new cost basis of $200,000).

Now let’s say the judge awards you $400,000, arguing that your condo would have increased in value if not for the new building blocking the view. In this case, $100,000 of your settlement is taxable because it exceeds your cost basis. The extra $100,000 is essentially profit for you and so is taxable income. In this scenario, however, you need not adjust your cost basis in the property.

Getting Taxed on Attorney Fees

When dealing with legal settlement taxation, it’s imperative to understand that you do not get a break on your legal fees. In the 2005 case of Commissioner v. Banks, the United States Supreme Court ruled (perhaps unfairly) that the IRS can tax all of a legal settlement even if you don’t receive it all due to legal fees.

What does this mean for you? This means if your attorney wins you a taxable $100,000 settlement, you will pay tax on $100,000 — even if your attorney keeps 40 percent of your money to cover his fees. It’s imperative to remember this when calculating your income taxes. You may be able to deduct your legal fees elsewhere on your return, but don’t reduce the amount of your settlement itself to accommodate legal fees.

How to Avoid Paying Taxes on a Lawsuit Settlement

Whenever possible, it’s best to contact a CPA as soon as possible when you know you’re getting involved in a lawsuit. They can help you try to hatch a plan to minimize your taxable income and, in some cases, may be willing to work with your attorney, together creating the best outcome for you from both a legal and a tax standpoint.

Even if it’s too late to get a CPA involved early, there is no wrong time to start planning ahead and preparing for the ways your lawsuit may impact you at tax time. You may, for instance, have to make estimated tax payments on your proposed settlement. A CPA can help you with that.

It’s also a good strategy to try and reach a settlement agreement without going to court if you can. This keeps your legal fees down, and paying less is always welcome. It can also help you avoid the trap of paying taxes on attorney’s fees and other money you’ll never get, as noted above.

We hope this crash course in lawsuit taxes is helpful, but we’ve in no way covered all of the intricacies that could impact you. As you can see, we weren’t exaggerating when we said the tax law pertaining to legal settlements is complex. Fortunately, we have CPAs at Picnic Tax who know settlement tax law like the backs of their hands, and they’re happy to share their knowledge with you. Reach out today and we’ll help you make sure that your settlement benefits you as intended rather than the IRS.