Settlements and court judgments: taxable or not?

How the IRS taxes three types of damage awards, and how to proactively mitigate the tax consequences

By: Andrew Walters  /  December 13, 2016

For most people, getting a monetary judgment or settlement as compensation for an injury or other claim in a lawsuit is good news. But taxpayers may be surprised when they owe a large tax balance on certain types of payments.

To get to the bottom of what an individual will owe (if anything), the first step is to determine whether all or part of the settlement or judgment is taxable. Then, depending on type of award, taxpayers and their advisors can take some proactive steps to reduce the tax impact.

Is the settlement or judgment taxable?

Generally, the IRS taxes income from any source, including awards in lawsuits or settlements. But there are several exceptions.

When trying to determine whether an award is taxable, look to the origin of the claim in the case. This is the legal argument that forms the basis for monetary or other relief to the plaintiff. For example, if a car hits a pedestrian, the origin of the pedestrian’s claim would be his or her physical injuries.

The tax treatment of four types of damages

Here’s how the IRS taxes four types of damage awards in settlements and court judgments, based on the claim’s origin.

1. Damages for injuries or sickness: Not taxable, with exceptions

If a taxpayer receives damages as compensation for a physical illness or injury, the award isn’t taxable, with certain exceptions. If the taxpayer previously deducted medical expenses resulting from the injury, the IRS may tax some or all of the damages, because the taxpayer already got the tax benefit from that expense in a prior year.

2. Lost wages or profits: Taxable, with exceptions

If a taxpayer receives judgments or settlements resulting from an involuntary termination, discrimination, or unpaid wages, the IRS will treat the award just like taxable wages that the taxpayer would have earned at his or her job.

The taxpayer should receive a Form W-2 reporting the income, federal tax withholding, and employment taxes. Even if the income isn’t reported on a Form W-2, the taxpayer should report the income, along with other wages, on his or her tax return. Awards that are compensation for other employment-related suits may also be taxable as other income.

3. Punitive damages: Taxable

Punitive damages are meant to punish wrongdoers who acted recklessly, or with malice or deceit. Punitive damages are almost always taxable, even when they’re included in a judgment or settlement for a claim that is based on physical injuries or a sickness.* Taxpayers should report punitive damages as other income on their personal tax returns.

4. Property damage: Not taxable, with exceptions

If a taxpayer receives compensation for property damage, the taxpayer must reduce his or her tax basis in the property by the amount of the settlement or compensation. The tax basis is usually the original cost of the property plus any improvements, less any depreciation for business use. If the damages are less than the adjusted basis of the property, the loss is not taxable income. If damages exceed the tax basis of the asset, the excess is treated as either capital gains income or ordinary income.

Example: A taxpayer had a basis of $10,000 in her car before the car was damaged by a crash caused by someone else. The taxpayer reached an insurance settlement for $4,000. Her new adjusted basis in the vehicle would be $6,000, and she wouldn’t owe tax on any additional income. If the taxpayer used the $4,000 to restore her car, that would also restore her basis for the amount she paid to repair her vehicle.

Repayments for itemized deductions are taxable

Even if a judgment or settlement isn’t taxable, part of the award could still be taxable if the portion is repayment for a tax-deductible itemized expense that the taxpayer claimed in a prior year. This repayment is known as a recovery of an itemized deduction.

Example: A defective appliance in a taxpayer’s home caused a fire and significantly damaged his home. The taxpayer deducted a casualty loss as an itemized deduction on his tax return in the year the fire occurred. In a future year, he receives compensation for the loss through a court settlement. While compensation for property damage wouldn’t ordinarily be taxable and would reduce his basis in the home, part of his compensation may be taxable, based on the amount of the casualty-loss deduction he took in the prior year.

Taxpayers may be able to deduct their legal expenses

In general, taxpayers can deduct legal fees they paid to collect a taxable judgment or settlement. The amount would be a miscellaneous itemized deduction, subject to a floor of 2 percent of adjusted gross income (AGI).

When taxpayers pay legal fees in certain lawsuits, they may be able to claim an above-the-line deduction directly on Form 1040. This means there is no 2 percent of AGI limitation, and taxpayers don’t have to itemize to claim the deduction. The types of lawsuits that qualify for this treatment are those with claims based on federal antidiscrimination statutes listed in Section 62(e) of the Internal Revenue Code.

Example: A taxpayer receives a taxable award as the result of an unlawful discrimination claim that she makes under federal civil rights or labor laws. She can deduct the legal expenses as an adjustment to her taxable income from the settlement, rather than deducting them as an itemized expense, subject to a floor of 2 percent of her AGI.

Two planning opportunities can mitigate tax impacts

When it comes to taxable damages, taxpayers and their advisors can be proactive to help mitigate surprisingly large tax liabilities and avoid underpayment penalties that can result from legal settlements. Here are two tips.

1. Properly allocate damages

Settlement agreements and court judgments can include more than one type of damage award, which could all be taxed differently. IRS audit guides state that the IRS will generally respect the existing allocations of damage awards in settlement agreements and court judgments. However, the IRS can audit a settlement agreement to ensure that it allocates damages according to the substance of the case.

Taxpayers’ attorneys should make sure that the settlement or judgment accurately allocates the types of damages to ensure that the tax treatment is also correct. In addition, tax professionals should review the judgment or settlement to ensure they properly report the items within it.

2. Make upfront tax payments

If some or all of the damages are taxable, taxpayers should consider making an estimated tax payment to avoid owing a large tax balance when they file their return. Calculating the tax impact of an award would also avoid any surprises and allow taxpayers to financially plan for the tax bill.

Planning is also important to avoid underpayment penalties if the settlement or judgment is expected to generate taxable income. Taxpayers can incur penalties for underpaying their estimated taxes if they failed to pay either 100 percent of the tax shown on their prior year’s return or 90 percent of their current year’s tax. No federal underpayment penalty applies if the tax due amount with the return is less than $1,000.

Review expenditures and plan ahead

Ultimately, individuals and their lawyers and tax advisors should carefully consider the tax impact of settlements and damage awards. They should review relevant expenditures – medical and legal – in the current and prior tax years to look for deductions, and take steps to understand whether the award is taxable.

Author’s note: Thank you to Deryk Doty, JD, who contributed to this article.

* Punitive damages are not taxable if they are awarded in a wrongful death lawsuit paid under a state law that requires that only punitive damages may be awarded in a wrongful death suit. The state law must have been in effect on or before September 13, 1995.

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Andrew Walters

Andy Walters, JD, is a former tax research specialist at The Tax Institute. Andy supported H&R Block customers who are preparing their own tax returns by providing answers to complicated tax questions.

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