Tax Time Tips: Is my Settlement Tax-Free?

It’s that dreaded time of the year again when Uncle Sam requires you to report your earnings. Whether you owe taxes or expect a return, it can be a taxing time just gathering all of the documents and completing the forms. And if that’s not enough to make your head spin, you also need to be wary of potential scams and identity theft.

The Internal Revenue Service offers a vast array of Current Tax Tips on its website, but we’ll highlight a few below that pertain specifically to litigations and settlements.

Our clients often ask if their settlements are tax-free. You cannot be taxed on money meant to compensate you for personal injuries, emotional distress caused by physical injuries, or the lost wages that result from the physical injury. Sounds simple, right? Unfortunately, it’s not that simple.

The IRS clearly states: “If you receive a settlement for personal physical injuries or physical sickness and did not take an itemized deduction for medical expenses related to the injury or sickness in prior years, the full amount is non-taxable.” However, there are exceptions to that rule! For example, if you previously deducted any medical expenses regarding your injury to the extent it provided a tax benefit then you must allocate and claim, on a pro rata basis, that part of the proceeds as “Other Income” on your current tax filing. Simply put, there is no double-dipping allowed.

There are similar rules regarding settlements for mental anguish and emotional distress as it relates to the physical injury or illness. If the money you received for it did not originate from the injury/illness, you must include it in your income. But, if it is related, the amount can be reduced by previously paid medical expenses attributable to the distress and anguish that were not previously deducted and/or did not provide a tax benefit.

Punitive damages, even if received in a settlement for personal physical injuries or physical sickness, are indeed taxable and the IRS declares you should report it as “Other Income.” Why you ask? Punitive damages are meant to punish the defendant for negligent behavior rather than compensate you for your injury.

Interest on settlements is also generally taxable, unless certain funds have been established from the beginning. The IRS requires you to report that interest as “Interest Income.”

Due to the complexity and case specific details, we always advise all of our clients to consult a tax attorney and/or personal accountant. There are a number of free or low-cost tax clinics across the U.S. You can find a list of available services in your area on the Taxpayer Advocates Website.