Are Legal Settlements and Judgment Awards Taxable Income?

The tax problem usually starts with a poorly drafted settlement agreement or judgment, followed by a notice of audit; and then comes the blaming of an attorney, especially if the person was self-represented.

The situation is more common than you would think; are the funds a party to a lawsuit receives through a settlement or judgment taxable income? Well, it depends on what the settlement funds or judgment funds are actually for. The underlying claim that is the basis for why the person received the funds is important and controls whether the funds are to be included as taxable income. Therefore, it is important for you and your attorney, if you have one, to understand the tax consequences of settlement funds, the language used in the settlement document, and what type of damages are being awarded in a judgment.

When determining whether a settlement or judgment is taxable or not, it is easiest to start with the premise or generality that virtually all judgments or settlements are taxable. The general exception to this general rule is that settlements and judgments where the underlying claims are based on some type of personal injury or sickness.

Settlement funds and judgments that compensate for physical injuries or sickness are generally excludable from taxable income. However, an exception to this rule is that funds used to compensate for medical expenses that were previously deducted for a tax benefit in prior tax years may not be excludable as income, even if the funds are based on an underlying physical injury or sickness.

Another red-herring that tends to be audit fodder is compensation for emotional distress. Compensation for emotional distress is excludable from taxable income if the distress compensated for flows directly from some type of underlying physical injury or sickness. However, compensation for emotional distress as a standalone tort claim, or that is not based on some actual physical injury or sickness is actually considered taxable income. Lastly, punitive damage awards are also generally taxable, even if they are based on a physical injury or sickness.

So when it comes to settlement or judgment income, you have a general rule, an exception to the general rule, and several exceptions to the exceptions of the general rule. Confused yet? When all these exceptions are coupled with the legalese applicable to settlements and judgments, it gets very confusing. Therefore, it is important to understand the tax consequences of the settlement or judgment amount because that legal windfall may not last you as long financially once the Internal Revenue Service takes its bite.