The Internal Revenue Code (IRC) states that all income is taxable from any derived source, unless exempt by another section of the code. This means that, in general, any amount received from the resolution of claims and other legal remedies is taxable. However, there are some exceptions to this rule. Damages for physical injury are not considered taxable income.
This includes any settlement money designated for medical expenses, even if it is the result of emotional injury. The tax liability of recipients of court settlements depends on the type of agreement. If you have already deducted medical expenses related to your injury, your damages will be taxable. You cannot get the same tax relief twice.
It is important to look into the details of a settlement agreement to determine if the proceeds are taxable or not. If you plan to issue a 1099 form, negotiate for a lower number than your actual settlement amount. If you do not have documentation on the amounts of each claim, the IRS may challenge the non-taxation of the settlement. Before signing a settlement agreement, make sure to define whether or not the defendant will issue a Form 1099. It may be beneficial to hire a tax accountant or tax attorney to help you navigate the post-liquidation process and stay on the right side of the law.
Emotional distress damages are generally taxable, but an exception arises if they stem from physical injury or manifest themselves in physical symptoms for which you seek treatment. When you receive a settlement or judgment, it may be wise to hire a tax accountant for that fiscal year, even if you normally do your taxes yourself online. Any pre-trial or post-trial interest in settlement money is taxable and may influence taxes on some attorney's fees. If all or part of your agreement was for back wages from a W-2 job, then you won't receive a 1099-MISC for that party.
If you have sued for damage to your home or commercial factory, you may be able to classify the settlement as capital gains. Having to pay taxes on your lawyer's part of your settlement can lead to a fairly high IRS bill. It is important to understand all aspects of taxation when it comes to court settlements so that you can make informed decisions and avoid any potential issues with the IRS.
