You have money coming to you from a pending law suit, but you’re wondering whether Uncle Sam will want a share of it. The answer varies, depending on various factors such as how you were damaged, how the case is resolved and more. Here are a few facts you should know before negotiating a settlement.
Physical injury awards
Damages from physical injuries are tax free, although punitive damages and interest paid on an injury award are taxable. Damages for emotional injuries, as well as physical symptoms caused by emotional distress are generally taxable.
Settling can reduce taxes
You may be able to reduce taxes if you settle, especially if you are mindful of the tax rules when negotiating. A settlement agreement could stipulate that all the cash was for a physical (non-taxable) injury. If left to a court verdict, a portion may be attributed to punitive damages or interest.
Assuming you don’t get back more than you paid for damaged property, it’s considered a “recovery of basis” and tax-free. Any recovery in excess of your basis might be taxed at the 15% capital gains rate.
While attorney fees in a business case are deductible as a business expense, in a personal case they can wreak havoc. The tax law treats you as receiving 100% of the settlement, even if a separate check is issued to the attorney. If the damage is non-taxable you have nothing to worry about, but if it is, watch out.
Severance pay is taxed and treated like wages (i.e. subject to tax withholding and payroll taxes) even though you no longer work for the company.
Damages for discrimination are taxed as ordinary income (i.e. not as wages; no payroll tax). A law in 2004 makes attorney fees for discrimination awards deductible “above-the-line” – so they don’t affect your tax liability.