In the wake of a legal victory, understanding the tax implications of your settlement or judgment can be a maze of complexity. Whether you've just triumphed in court or are weighing your legal options, grasping the financial consequences is paramount. Below we will try to demystify the taxability of plaintiff awards, drawing insights from the authoritative guidance of the Internal Revenue Service (IRS).
The General Rule: The Taxman Cometh...
At the heart of any discussion on the tax ramifications of legal proceedings lies the Internal Revenue Code (IRC) Section 61. This foundational code stipulates a sweeping principle: all income, regardless of its source, falls under the umbrella of gross income unless explicitly exempted by another section of the code. In simple terms, the general rule dictates that any financial gains stemming from legal actions are taxable.
...But There's More to the Story
While the general rule paints a broad stroke of taxation, exceptions abound in the realm of lawsuit settlements and judgments. Unlocking these exceptions hinges on IRC Section 104, which carves out exclusions from taxable income for specific categories of lawsuit settlements and awards. The nature of the payment and the circumstances surrounding it play a pivotal role in determining its taxability.
Physical Injury or Sickness
Among the notable exceptions are damages received due to personal physical injuries or sickness. According to IRC Section 104(a)(2), such damages—whether from a lawsuit, settlement, or periodic payments—are generally exempt from inclusion in gross income. This exclusion encompasses compensatory damages intended to cover losses and even punitive damages aimed at penalizing the offender.
Emotional Distress and Other Non-Physical Injuries
The tax treatment of damages stemming from emotional distress or non-physical injuries requires a more nuanced approach. Typically, these damages are included in gross income, unless directly linked to a physical injury or sickness. However, expenses for medical treatment related to emotional distress, not previously deducted, may qualify for exclusion.
Punitive Damages
Punitive damages typically fall under taxable income, save for specific exceptions in certain wrongful death cases where state law limits punitive damages.
Employment-Related Lawsuits
Damages received for employment-related disputes—such as wrongful termination or discrimination—are typically taxable. This encompasses compensatory damages covering lost wages or benefits. However, the tax treatment can vary based on case specifics and award nature.
The Power of Documentation
The tax treatment of any settlement or judgment hinges on case specifics and payment characterization. Adequate documentation, including settlement agreements, plays a pivotal role in deciphering the tax implications. A clear understanding of the claim's nature and payment characterization is crucial in evaluating taxability.
Reporting Requirements
Recipients of lawsuit settlements or judgments may face reporting obligations. Depending on the settlement nature, the payer—be it an insurance company or the defendant—may need to issue a Form 1099 to the IRS. Tax exceptions may alleviate reporting requirements.
Seek Professional Help
Navigating the tax implications of plaintiff awards is paramount for individuals embroiled in legal disputes. While the general rule dictates taxable income, exceptions exist—especially concerning damages related to personal physical injuries or sickness. Taxpayers should meticulously assess settlement or judgment nature, and seek counsel from this office to ensure compliance and optimize your tax situation. While the IRS offers resources and guidance, the complexity of individual cases often necessitates expert advice.
The terrain of tax consequences in legal settlements may be daunting, but armed with knowledge and guidance, taxpayers can confidently navigate the financial aftermath of their victories.
Sign up for our newsletters and get our articles delivered right to your inbox.
Check the background of your financial professional on FINRA's BrokerCheck
Avantax affiliated Financial Professionals may only conduct business with residents of the states for which they are properly registered. Please note that not all of the investments and services mentioned are available in every state. Securities offered through Avantax Investment Services℠, Member FINRA, SIPC, Investment Advisory services offered through Avantax Advisory ServicesSM, Insurance services offered through an Avantax affiliated insurance agency. 3200 Olympus Blvd., Suite 100, Dallas, TX 75019. 972-870-6000.
The Avantax family of companies exclusively provide financial products and services through its financial representatives. Although Avantax Wealth Management® does not provide or supervise tax or accounting services, Avantax representatives may offer these services through their independent outside business. Content, links, and some material within this website may have been created by a third party for use by an Avantax affiliated representative. This content is for educational and informational purposes only and does not represent the views and opinions of Avantax Wealth Management® or its subsidiaries. Avantax Wealth Management® is not responsible for and does not control, adopt, or endorse any content contained on any third party website.
This information is not intended as tax or legal advice. Please consult legal or tax professionals for specific information regarding your individual situation.
The information being provided is strictly as a courtesy. When you link to any of the web sites provided here, you are leaving this web site. We make no representation as to the completeness or accuracy of information provided at these web sites. Nor is the company liable for any direct or indirect technical or system issues or any consequences.
For Important Information and Form CRS please visit https://www.avantax.com/disclosures.