After you receive your lawsuit settlement and your attorney takes his share, it's likely that Uncle Sam will also want a cut of the proceeds. The reason for the compensation you receive in your settlement determines whether it is taxable. Since many lawsuit settlements compensate you for more than one reason, part of your settlement might be taxable income and the other part not taxable. You might also owe additional employment taxes for wages or business income. You must examine each component of your settlement individually to determine what kind and how much tax you owe.
Physical Injuries and Physical Sickness
Any component that compensates you for physical injuries or physical sickness is not taxable. This includes compensation for medical bills, lost wages, pain and suffering and attorney's fees. However, if you deducted medical expenses related to the physical injuries or sickness in prior years and the deduction resulted in a tax benefit to you, you must allocate part of the proceeds for each year you took a deduction that resulted in a tax benefit. The Recoveries section of IRS Publication 525, "Taxable and Nontaxable Income," describes how to calculate the amount you must allocate, which you should record as Other Income on line 21 of Form 1040.
Emotional Distress and Mental Anguish
If a component of your settlement compensates you for emotional distress or mental anguish that originates from a personal physical injury or physical sickness, that component is also not taxable. However, if you deducted medical expenses in prior years related to the emotional distress or mental anguish, you must include the full amount of your deductions as taxable income, even if the deductions did not provide a tax benefit to you.
Interest and Punitive Damages
Some portions of your settlement might be taxable even when they relate to physical injury, sickness, emotional distress or mental anguish. For example, if your award contains an allocation for interest, the interest is usually taxable. If a portion of your award is for punitive damages, that portion is also usually taxable.
A property settlement that compensates you for the value you lost in a property is usually not taxable as long as it's less than the adjusted basis of the property. However, when you sell the property, you must reduce your basis in it when you calculate your capital gain on the sale. If the settlement exceeds your adjusted basis in a property, the difference in the settlement amount and your basis is capital gain income. Refer to Form 4797, "Sale of Business Property," and report the income on Schedule D of Form 1040.
Lost Wages, Back Pay and Severance
If your settlement is related to an employment lawsuit such as wrongful termination or discrimination, the settlement is usually taxable. If a component of the settlement is for lost wages, such as back pay or severance, you also owe Social Security and Medicare tax on the wages at the prevailing rates for the year in which you earned them. You must report the wage portion of your award as wages on line 7 of Form 1040.
Lost Profit for Self-Employed Individuals
Most settlements are taxable when they compensate an individual for lost profit from a business. However, the portion of the settlement that relates to the business must be recorded as business income and is also subject to self-employment tax. Report the income on line 12 of Form 1040.
An award for any other reason, such as breach of contract or emotional damage not related to physical injury or sickness, is usually taxable income to you.