You’ve just received an award as the prevailing party in a lawsuit and it’s just a few weeks before the April 15th tax deadline. As you organize your documentation for the preparation of your taxes, you suddenly wonder if you have to pay taxes on the legal proceeds that you received a few weeks earlier. Are they indeed taxable? Whether you must include the amount of the proceeds in your income depends on all the facts and circumstances of each individual case. It also depends upon the type of injury incurred.
As to awards for personal physical injuries or physical sickness, if you receive proceeds for these types of damages and did not take an itemized deduction for medical expenses related thereto in prior years, the full amount is non-taxable. If you did make a deduction for medical expenses, you must include in income that portion of the award or settlement that is for medical expenses you deducted prior to the present tax year to the extent any of the deductions provided a tax benefit. If part of the proceeds is for medical expenses you paid in more than one year, you must pro rate that part of the proceeds to each of the tax years that you incurred medical expenses.
Proceeds received for emotional distress or mental anguish originating from a personal physical injury or physical sickness are treated the same as proceeds received for personal physical injuries or physical sickness discussed above. IRC § 104(a)(2). If such proceeds do not originate from a personal physical injury or physical sickness, you must include them as income. However, the amount you must include is reduced by: (1) amounts paid for medical expenses attributable to emotional distress or mental anguish not previously deducted and (2) previously deducted medical expenses for such distress and anguish that did not provide a tax benefit.
The taxpayer must attach to his or her return a statement showing the settlement amount in full less related medical costs not previously deducted and medical costs deducted for which there was no tax benefit. The taxpayer should report this net taxable amount as “Other Income” on Form 1040, specifically line 21.
If you receive an award or settlement for unlawful discrimination or involuntary termination, or some other claim under labor or employment law; that portion of the proceeds received for lost wages is taxable as wages and subject to the social security wage base and social security and Medicare tax rates for the year paid. These proceeds are subject to employment tax withholding and should be reported by the taxpayer as on line 7 of Form 1040 as “Wages, salaries, tips, etc..”
If you receive a settlement for lost profits from your trade or business, you will report that portion of the proceeds attributable to carrying on your trade or business as net earnings, which is subject to self-employment tax. These taxable proceeds should be included in “Business income” reported on line 12 of Form 1040. These proceeds are also included on line 2 of Schedule SE (Form 1040) for computing self-employment tax. For more information about reporting lost profits awarded in a legal proceeding as self-employment income and paying self-employment tax, see an experienced tax attorney.
Property awards or settlements for loss in value of property are not taxable and do not need to be reported on your tax return as long as they are less than the adjusted basis of your property. However, the basis in the property must then be reduced by the amount of the settlement. If the property award or settlement exceeds the adjusted basis in the property, the excess is income.
Interest on any settlement is generally taxable as “Interest Income” and should be reported on line 8a of Form 1040. Punitive damages are taxable and should be reported as “Other Income” on line 21 of Form 1040, even if the punitive damages were received in a settlement for personal physical injuries or physical sickness.
Because each case is different and has its own set of facts and circumstances, it is important that upon receiving (or anticipating) any legal settlement, you should consult with an experienced and knowledgeable tax attorney to determine the taxable and non-taxable portions of your award. Your experienced tax attorneys and CPAs at Thorgood Law Firm www.thorgoodlaw.com can help answer questions about whether the proceeds of a lawsuit constitute taxable income. For a FREE consultation, call 212-490-0704.
