Taxability on Settlements
A question we often get asked is,
“If I receive money from a lawsuit settlement, how do I determine whether or not I should include that in my income for the year?”
We’ll be going through the various circumstances of taxable settlements here; the IRS provides some helpful guidance. However, Nigh Goldenberg Raso & Vaughn does not practice tax law and you should consult your accountant and tax attorney for guidance on your specific situation.
When Settlements Are Not Likely Taxable
The IRS lays out several circumstances where settlements are not likely taxable. These include:
- Receiving a settlement for personal physical injuries or physical sickness (as long as an itemized deduction for medical expenses related to the injury or sickness was not previously taken), or
- Receiving a settlement for emotional distress or mental anguish that are connected to a personal physical injury or physical sickness.
When Settlements May Be Taxable
However, there are certain circumstances where a settlement may be taxable. These include:
- Settlement money you received that does not originate from a personal physical injury or physical sickness,
- A settlement in an employment-related lawsuit — the part of the settlement money allocated for lost wages is taxable and subject to the Social Security wage base, Social Security tax rates, and Medicare tax rates in effect during the year it was paid,
- A settlement for lost profits from your trade or business — the portion of the funds used to keep your business or trade functioning is considered net earnings, which are subject to self-employment tax,
- If you receive interest on your settlement, then the interest is typically taxable, and
- If you receive punitive damages.
