When it comes to taxation of settlements and judgments, the Internal Revenue Service (IRS) has a few rules that you need to be aware of. Generally speaking, money received in a lawsuit is taxed based on its purpose. If the payment represents damages for loss of profits, it is usually taxable as ordinary income. On the other hand, if the payment is for a return of destroyed or injured capital, it is not taxable to the extent that it does not exceed the basis of the property.
Additionally, attorneys' fees are generally not considered wages for employment tax purposes. The IRS does not pay personal injury settlement awards if these cases demonstrate “observable bodily harm”. Most settlements are for various types of damages, such as loss of income, emotional distress, medical expenses, and other costs. It doesn't matter if the compensation comes from a court-ordered award or an out-of-court settlement, or if it's paid in a lump sum or in installments.
Settlement money and damages collected in a lawsuit are considered income, which means that the IRS will generally tax that money. Any pre-trial or post-trial interest in settlement money is taxable and may influence taxes on some attorney's fees. Depending on the nature of your claim, you may be able to treat part of your settlement as capital gains. In the case of claims against a negligent builder for property damage, the settlement may be considered a reduction in the purchase price of the property rather than income. The Tax Court recently held that settlement proceeds received in a malpractice lawsuit against a taxpayer's lawyers were, in fact, taxable.
It is important to note that punitive damages are always taxable and can result in high taxes. Furthermore, taxes on liquidations can vary widely. It is important to understand how settlements and judgments are taxed so that you can plan accordingly and make sure you are paying the correct amount of taxes. If you have any questions about how your settlement or judgment will be taxed, it is best to consult with a qualified tax professional.
