If you have received a settlement or award for damages from a lawsuit, you will need to take into account how you will be taxed on the sum. How and whether you are taxed depends on the type of damages you receive, as well as the nature of the lawsuit. According to tax laws, the only damages that you can be awarded without paying taxes are those that compensate you for physical injury or sickness.
Generally, the proceeds a person has received from a personal injury claim are not taxable under either federal or state law, regardless of when the case was filed and whether or not it went to trial.
What Kinds of Damages Are Not Taxable?
The only damages you can enjoy tax-free are compensatory damages that compensate for physical injury or physical illness. However, to the extent your award compensates you for medical expenses that you used as an income tax deduction in a previous year, that amount will be taxable. Additionally, damages you receive that compensate for emotional distress that directly resulted from your physical illness or injury is also non-taxable.
What Types of Damages Are Taxable?
There are some exceptions to the general rule. Damages that compensate you for anything other than physical injury and illness are generally taxable. Taxable items include:
- Compensation for lost wages out of an employment discrimination lawsuit, as these would have been taxed had you received them as a paycheck. They are subject to employment taxes.
- Punitive damages, even if they result from an award for physical illness or injury
- Lost profits
- Interest received on a settlement or damage award
- Damages related to a breach of contract
- Damages for patents or copyright infringement cases
- Damages for interference with business operations
Can an Award Place Me in a Higher Tax Bracket?
Any award you receive is added to your total taxable income for the year. This could mean higher taxes if your award is large enough to place you in a higher tax bracket. You might be able to avoid this effect if you have the option of receiving payments over time.
Is an Award for Attorney’s Fees Taxed?
Plaintiffs are taxed on the entire amount of the award, including any portion he or she will use to pay an attorney’s fees. Attorneys who represent plaintiffs are usually paid on a contingency basis, meaning that the attorney gets paid if the client wins the case. The contingent fee is deducted from the award and given to the attorney as a payment for representation. You must pay tax on the entire award you receive, including the amount taken out and paid to your attorney. Also, if the defendant is ordered by the court to pay your attorney fees, the amount must be included as taxable income.
Should I Speak to a Lawyer?
If you have received a settlement or award of damages from a lawsuit, you may want to speak to a tax attorney about the best way to structure the award and how to report it on your tax return.