The Internal Revenue Code (IRC) states that all income is taxable from any derivative source, unless it is exempt by another section of the code. The tax liability of a litigation agreement depends on the type of agreement. Generally, damage caused by a physical injury is not considered taxable income. However, if you have already deducted medical expenses for your injury, your damages will be taxable.
You can't get the same tax break twice. In terms of terminology, a judgment refers to a formal judicial resolution of a dispute, in which the court may order one party to pay financial compensation to another. An agreement refers to a mutual agreement between litigants. Agreements are a different process than award by a court, binding arbitration, or other types of formal hearings. However, for tax purposes, judgments and liquidations are treated the same way. The general rule for the taxation of amounts received as a result of the resolution of lawsuits and other legal remedies is section 61 of the Internal Revenue Code (IRC), which states that all income is taxable “unless there is a specific exception from any source of origin, unless it is exempt by another section of the code.” Perhaps the biggest exception to that rule is reaching agreements to compensate for personal injuries.
The IRS excludes some, but not all, income from lawsuits, settlements, and awards from taxes. If you get a settlement of a lawsuit, it could be for one of several reasons. Your agreement may constitute compensation for losses resulting from a physical injury or damage caused by another type of injury. Some or all of the compensation may be due to various types of emotional distress or punitive damages awarded by the court due to the defendant's heinous conduct. A lawsuit that arises from an injury that occurred in an accident may have more than one type of claim for damages. Some of these are taxable, while others are not.
In certain business disputes, the IRS taxes a loss of profit agreement as ordinary income. Depending on the circumstances, compensation for lost wages, wrongful termination, or severance pay may be subject to taxes such as income. If you win compensation for damage to your home caused by a negligent builder, rather than taxable income, the IRS may treat that compensation as a reduction in the purchase price of the property. Clearly, the intricate rules are full of exceptions. Therefore, if you file a lawsuit after suffering a physical injury, such as in a car accident or other type of personal injury, the IRS considers that the compensation you will receive after reaching a settlement is not subject to taxation.
Note that this does not include punitive damages, which are taxed by the federal government. The tax status of personal injury settlements can be confusing because compensation in personal injury cases often includes reimbursing losses, such as lost wages, that would otherwise be subject to taxation. In any case, whenever the source of a claim is due to personal physical injury or physical illness, those compensatory damages are exempt from tax under section 104 of the tax code. However, if you deducted any of your medical expenses in previous years, you must declare the settlement funds as income since you can't use the same tax break twice. Examples of invisible injuries include sexual harassment, slander or defamation.
Emotional distress is different from non-visible injuries but is managed in a similar way. Recoveries for physical injuries and physical illnesses are tax-exempt but the symptoms of emotional distress aren't physical. This area of law becomes very complicated; did the physical injury cause emotional distress or did emotional distress cause physical symptoms? In short, if the defendant caused your physical injury it's a tax-exempt event but if emotional distress made you physically sick you're likely to be subject to taxation. Before 1996 no personal injury was taxed; therefore settlements for claims such as emotional distress and defamation were tax-exempt. However since 1996 only money from physical injury settlement has not been taxable; compensation for emotional distress is not taxed only if it originated as a result of personal physical injury or physical illness. Courts have distinguished between signs and symptoms; symptom being “subjective evidence” and sign being evidence perceptible to examining physician. In some circumstances court may award punitive damages; these damages are awarded as form punishment to those found responsible for lawsuit and are independent from compensatory losses; punitive damages are generally taxable however they depend on state. Attorneys fees are another complex area when it comes to taxation of litigation settlements; if your lawyer represents you in personal injury lawsuit with contingency fee you can pay taxes on 100 percent money you and your lawyer recover even if defendant pays contingency fee.
