If you recently received money as part of a settlement or award for a lawsuit, have you thought about how that settlement or award will affect your taxes? Depending on the nature of your claim, you’ll probably have to pay taxes on that money, just like you would on any other form of income. Whether you’ve already received your award, or you’re thinking of settling a legal dispute, here’s what you need to know:
The Origin of the Claim
Not all awards come in the form of monetary payment. For example, if you sue your employer for loss of income, for whatever reason, then any award you receive will be taxed as wages. If, on the other hand, you bought a car that turned out to be defective and you sue the manufacturer, you might be able to treat any award you receive as a reduction in the price you paid for the car.
Physical Injuries and Illness vs. Emotional Distress
If you sue your employer for physical injuries sustained while on the job, or if you sue your doctor for medical malpractice, those awards are not subject to taxation. While you can also sue for “emotional distress” caused by the incident, any amount granted for that will be taxed.
Allocate Your Damages
If you do sue for something like emotional distress, as well as physical damages, talk with the defendant about allocating your damages, so you receive individual payments for each claim, instead of one lump sum. This will allow you to save taxes on the tax-free awards, such as physical damages, without having to worry about separating out the part of the funds for emotional distress. Your agreement with the defendant will not be binding, and there’s no guarantee the IRS will abide by it, but it’s worth a try.
Taxes on Punitive Damages and Interest
In addition to covering the up-front costs of the damage done, most plaintiffs also sue for punitive damages, which are essentially a way of literally making the defendant pay for their transgressions. Depending on the law(s) that was allegedly broken, there might be a provision in the law for the amount of punitive damages a plaintiff can claim when suing for a violation of that law, but that part of the award will always be subject to taxation. For example, if you suffer physical injuries and/or illness, then, as previously mentioned, the part of the award that covers those costs won’t be taxed, but if you are also awarded punitive damages, you will have to pay taxes on that money.
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