Lawsuits are one of those things that people always want to avoid. They don’t like being sued and don’t like paying up. When it comes to lawsuits, there are some exceptions. For example, most personal injury claims will not be taxed. This includes cases where someone falls off a ladder, slips, is hit by a vehicle, etc. Personal injury claims include anything related to physical injuries. For instance, if you are injured because of a product defect, you could file a lawsuit against the manufacturer.

The same goes for medical malpractice cases. These cases are usually filed against doctors, nurses, hospitals, etc., often involving negligence. A lawsuit involving medical malpractice is typically filed against the doctor, nurse, hospital, or device maker. Many states require that a patient sign a waiver before receiving treatment.

Knowing how much money you might receive if you are involved in a lawsuit, whether a car accident, a slip, a fall or even something else, is crucial. You might be surprised to learn that most of your money will be taxable. This includes your payments to lawyers, experts, and court costs.

Taxes aren’t just about filing paperwork, either. Filing taxes early allows you to take advantage of deductions. If you itemize your expenses, you can deduct certain items such as mortgage interest, property taxes, charitable donations, and state/local sales taxes.

You can also use tax breaks to reduce the amount of money you owe. Many employers offer tax-free allowances for health insurance premiums and retirement plans. Tax credits are also provided for dependent children, tuition, and student loans.

A Denver tax attorney has prepared the article below to provide additional information relating to whether or not proceeds from a lawsuit settlement need to be included in gross income on your individual income tax return. Please remember that this article is for informational purposes only, and you should consult your tax attorney or tax advisor regarding your specific facts and circumstances.

IRC Section 61 & Regulation 1.104-1

The two most commonly used exceptions for damages are amounts paid for discrimination claims and amounts paid for physical injury. Under IRC Section 61, all payments from any source constitute gross income unless there is a specific exclusion. The two main exceptions for damages are amounts paid for personal physical injuries or illness. Under section 104(a), damages received for such injuries or illnesses are excluded from gross income. This includes both settlements and judgments.

Under Treasury regulation 1.104-1, damages received on physical injuries or sickness include those received on account of personal bodily injuries or physical illness. Damages received on account of personal injuries include damages received on account

of personal bodily injuries, including pain and suffering, disability, loss of consortium, hospitalization, medical care, rehabilitation, vocational training, education, interest, attorney fees, litigation costs, criminal fines, awards against third parties, and losses resulting from the death. Damages received on accounts of physical illness include damages received on account of physical illness, including pain and suffering.

Awards & Settlements Tax

Awards and settlement taxes can be divided into two groups to help you understand how much tax you owe. These two groups include claims relating to physical injuries and non-injury-related losses. Each type of claim falls into one of three categories: actual damages, emotional distress damages, and punitive damages.

Within these three categories, awards and settlements often fall into several subcategories. For example, there are awards and settlements involving personal injury, property damage, product liability, and wrongful death. There are also awards and settlements involving physical injuries, such as bodily harm, medical expenses, lost wages, pain, and suffering, etc., and non-physical damages, like loss of consortium, defamation, false light invasion of privacy, etc.

These different types of awards and settlements can be further broken down into four separate categories:

• Actual Damages Resulting From Physical Injuries
• Emotional Distress Damages Arising From Actual Physical Injury
• Non-Physical Damages Arising From Physical Injury
• Punitive Damages

Factors To Consider When Settling Lawsuits

When it comes to settling lawsuits, there are many factors to consider. One crucial factor is how much money you receive and what type of damages you receive. You could pay extra taxes if you settle for less than you deserve.

In most cases, settlements are taxable income. This means you must report the amount you receive as income on your federal income tax return. You may also owe additional taxes if you received part of the settlement due to a physical injury or sickness.

Tax law allows deductions for payments made to compensate for injuries sustained in accidents. Payments to satisfy claims for lost wages, medical expenses, pain and suffering, and punitive damages do not qualify for a deduction. To determine whether you qualified for a deduction, look at the settlement document carefully.

The settlement document should contain information about how much money you received and how the money was allocated. A settlement letter usually includes a breakdown of the allocation, but the letter itself does not constitute proof. Therefore, it is essential to keep copies of the original settlement papers.

You should also retain any correspondence regarding the settlement, including letters from lawyers and court officials. These documents may help clarify the terms of the settlement and provide evidence of the allocation of the settlement proceeds.

Useful Settlement Tax Documents

The IRS has published three documents related to settlements arising from personal injury claims. These include the following:

CC PMTA 2009-035

This document addresses the tax consequences of such settlements and the proper treatment of the part of the judgment attributable to lost wages.

Publication 4345

Taxability provides general information about settlements and how to treat them for federal income tax purposes.

Rev. 85-97

The entire amount received by an injured person in settlement of a suit brought against another party for personal injuries sustained in a motor vehicle accident is excludable from their gross income.

Rev. 61-1

Clarifies the application of Rev. 85-97 to cases involving multiple plaintiffs.

Need More Information?

The above article has been prepared by John McGuire of the McGuire Law Firm. John is a Denver business attorney and tax attorney. Please contact The McGuire Law Firm directly with questions, comments, or concerns. Call us at 720-833-7705.

If your lawsuit is an employment-related lawsuit for a claim such as involuntary termination or unlawful discrimination, the proceeds received for lost wages, severance pay, or back pay are considered taxable wages and are subject to self-employment tax. Thus, these settlement proceeds are subject to federal income tax, social security tax, and Medicare tax.  Furthermore, these proceeds should be subject to withholding and therefore the payor (generally the employer) should issue a W-2 to report the wages or salary (income) and taxes withheld.  You would thereafter need to report this income on your 1040 individual income tax return.

What about lost profits from a trade or business.  Settlement proceeds received from lost profits will also be subject to self-employment tax and would be included in your business income.  Issues and facts may vary, but in general, proceeds for lost profit would be reported as income to your business as if the business had made the money.

What if your lawsuit involves property and the lost value of property or loss in value of the property?

If the settlement amount for a loss in value of the property is less than the adjusted basis in the property, then the settlement amount should not be taxable, but you need to remember to thereafter reduce the adjusted basis in the property by the settlement amount for future gain or loss determinations.  On the other hand, if the settlement amount you receive exceeds the adjusted basis in the property, this excess amount is income.  The income may be capital gain income, and a full discussion of this issue would be better served in a separate article.  You can review the instructions for Form 4797 and Schedule D, which discuss capital gain & loss, and the Sale of Business Property.

What if a portion of my settlement proceeds are allocated for interest?  Generally, the interest portion of the settlement would be taxable as interest income, and thus would be subject to ordinary income tax.

What about punitive damages?  Punitive damages are generally considered “other income” and thus would be subject to ordinary income tax. Please note, that you may be required to make estimated tax payments based upon your settlement amount, which you can review under IRS Publication 505.

John R. McGuire is a tax attorney and business attorney at The McGuire Law Firm.  John’s practice focuses primarily on tax issues & matters before the IRS, tax planning for businesses & individuals, and business transactions and contracts from the formation of a business to the sale of a business.  John can be reached at John@jmtaxlaw.com

You can contact The McGuire Law Firm to schedule a free consultation with a tax attorney in Denver, Colorado, or Golden, Colorado.