by Dennis E. Rinck, Jr, Owner of Rivertown Law Center
After months, or sometimes even years of insurance adjusters, attorneys and courtrooms, you finally settle your lawsuit or get a monetary judgment in your favor. The money you deserve is finally coming your way. However, don’t start celebrating too much just yet, because you may have forgotten one invitee to the party: the IRS.
If you receive money from a judgment or settlement, you may have to pay taxes on that money, depending on the circumstances of the matter, the basis of the damages and the types of damages upon which the monetary award was given. As typically the case with taxes, the possible tax implications of your award can be confusing to sort out, but need to be addressed especially when you receive large amounts of money.
Whether recovery is because of a jury award, judgment or an out of court settlement (even in the early stages of a claim prior to filing a lawsuit), the same tax rules will apply. This means it’s vital, especially in larger claims, that you seek advice from a lawyer or tax professional or both so that your case can be set up initially to minimize the future tax liability.
After you collect a settlement or judgment, the IRS typically regards that money as income, and taxes it accordingly. However, every rule has exceptions. Most notably, the IRS does not tax awards for personal injury cases, as long as the injury or sickness is physical in nature. The IRS does not specifically define physical injury, but calls it “observable bodily harm.” Although a recovery for personal physical injury is tax-free, any legal interest or punitive damages (monetary awards intended to punish or make an example out of a defendant) awarded will always be considered taxable income, regardless of the nature of the underlying matter.
In contrast with physical personal injury, damages received on account of non-physical injury or sickness, such as defamation, discrimination, injury to reputation and emotional distress (not caused by physical injury) just to name a few, are not excludable from taxable income. Although it may be obvious, any damages awarded in otherwise taxable categories such as lost wages, back pay, lost profits, breach of contract, interference with business operations or copyright infringement are generally taxable as ordinary income.
Nearly every piece of litigation, other than cases involving strictly physical injuries, will eventually sprout tax issues on some level. Although it is tempting to just bring your dispute to a conclusion, collect your money and let the tax chips fall where they may, that is a mistake. Ideally at the beginning of your case, but especially before you resolve your case and sign any settlement agreements, consider the tax aspects. Proper planning of case strategies from the beginning and utilizing the right language in lawsuits and closing documents can likely save you money when the IRS comes knocking. This information has been provided for informational purposes only and is not intended and should not be construed to constitute legal and/or tax advice.