How do I handle taxes if I received a settlement or legal award?

Tax Implications for Reporting a Legal Settlement or Award

Taxability of Settlements and Judgments

The tax implications of reporting a legal settlement or award on an individual's tax return can be complex and depend on the nature of the settlement or award. According to the Internal Revenue Code (IRC) Section 61, all income is generally taxable unless specifically exempted by another section of the code. IRC Section 104 provides exclusions for certain types of settlements and awards, particularly those received on account of personal physical injuries or sickness.

Exclusions from Gross Income

- Damages received on account of personal physical injuries or physical sickness are generally excludable from gross income under IRC Section 104(a)(2).

- The exclusion applies to amounts received through prosecution or settlement agreements in lieu of prosecution.

- The exclusion does not apply to punitive damages, which are generally taxable.

Taxable and Non-Taxable Awards and Settlements

Awards and settlements are typically divided into two groups for tax purposes:

1. Claims relating to physical injuries (non-taxable)

2. Claims relating to non-physical injuries (taxable)

Within these groups, claims usually fall into three categories:

- Actual damages resulting from physical or non-physical injury

- Emotional distress damages arising from the actual physical or non-physical injury

- Punitive damages

Specific Rulings and Examples

- Rev. Rul. 85-97 states that the entire amount received for personal injuries, including lost wages, is excludable from gross income.

- Rev. Rul. 96-65 clarifies that back pay and damages for emotional distress received for employment discrimination under Title VII are not excludable from gross income.

Reporting Requirements

- Personal physical injuries or sickness settlements that are non-taxable do not need to be reported on the tax return.

- Taxable settlements, such as those for non-physical injuries or punitive damages, should be reported as "Other Income" on Form 1040, Schedule 1.

- Interest on any settlement is taxable and reported as "Interest Income."

- Lost wages or profits from employment-related lawsuits are taxable and subject to employment taxes.

Special Considerations

- If a settlement includes amounts for medical expenses previously deducted, the tax benefit amount must be reported as income.

- Emotional distress or mental anguish not originating from a physical injury or sickness is taxable, reduced by certain medical expenses.

Documentation and Reporting

For accurate reporting and compliance, individuals should refer to the following IRS publications:

- [Publication 4345], Settlements – Taxability

- [Publication 525], Taxable and Nontaxable Income

- [Publication 17], Your Federal Income Tax

These publications provide detailed guidance on the tax treatment of various types of settlements and awards, as well as instructions on how to report them on tax returns.

Conclusion

Determining the tax implications of a legal settlement or award requires careful examination of the nature of the payment and the specific tax laws that apply. Taxpayers must consider the origin of the claim, the type of damages awarded, and any specific rulings or provisions that may affect the taxability of the settlement or award. It is crucial to follow IRS guidelines and report the appropriate amounts on the tax return to ensure compliance with tax laws.

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Sources:

Publication 4345 (Rev. 9-2023) - Internal Revenue Service 2024-08-03

Publication 525 (2023), Taxable and Nontaxable Income 2024-08-03

Publication 17 (2023), Your Federal Income Tax - Internal Revenue Service 2024-07-29

Publication 504 (2023), Divorced or Separated Individuals 2024-08-02

Publication 957 (01/2024), Reporting Back Pay and Special Wage Payments 2024-08-03

Topic no. 452, Alimony and separate maintenance - Internal Revenue Service 2024-08-03

pmta2009-035, Office of Chief Counsel Internal Revenue Service memorandum 2024-08-02

Tax Implications of Settlements and Judgments - Internal Revenue Service 2024-08-03

Whistleblower Office - Internal Revenue Service 2024-08-04

Publication 15-A (2024), Employer's Supplemental Tax Guide 2024-08-02