Ever Wonder if Lawsuit Settlements and Verdicts are Taxable?

July 8th, 2010. By Kristine B

It’s probably one of the biggest questions people involved in lawsuits ask. Is my settlement money taxable? (In other words, how much of this money do I get to keep and how much of it goes to the government?) This week, Pleading Ignorance examines settlements/verdicts, and how much of the money really is yours.

Like everything in life, what is and isn’t taxable is complicated. Whether or not the money in a settlement is taxable depends on a number of factors, because nothing in income tax is ever simple. According to Jeff Schnepper at moneycentral.msn.com (12/04/09), there must be a physical injury for the settlement to be free from tax. So, an award for wrongful termination would be taxable because there is no physical injury.

In fact, there are two requirements to ensure a settlement (or a verdict) is tax-free. The first, as mentioned before, is that there must be a physical injury (which includes illness). Without physical injury, you’re paying taxes.

The second is that the injury must have been caused by a wrongful act. This means that the other party must have committed a wrongful act, which caused your injury. So, if someone was negligent and injured you, your award or settlement would be tax-free. But, if the lawsuit was caused by a dispute that didn’t involve wrongdoing, the award would be taxable.

Punitive damages are taxable, regardless of whether or not they are related to a physical injury. The government taxes citizens on income and punitive damages; because they are not compensating the plaintiff for money lost, those damages are seen as above and beyond what would be needed to make the victim whole.

Emotional distress is not considered a physical injury. So, even if emotional distress results in your feeling ill, emotional distress on its own is taxable. Emotional distress is tax-free when it is linked to a physical injury. For example, if you injure your neck and this results in emotional distress, your award for emotional distress is tax-free.

If, however, you were wrongfully terminated from your job and this resulted in emotional distress, any award for emotional distress is taxable.

Awards for lost wages are, in most cases, taxable because they replace income that would have been taxable.

Tags: Pleading Ignorance, Settlement, Settlement Money, Tax

This was posted on Thursday, July 8th, 2010 at 1:58 pm and is filed under Emerging Issues, Pleading Ignorance, Settlement . Feel free to respond, or trackback. Read our comments policy.