Top Legal Settlement Question: Are Lawsuit or Court Awards and Settlements Taxable Income?

Personal injury lawsuits are often grueling, drawn-out affairs, and when a person is awarded compensation through a verdict or settlement it can feel like the weight of the world is lifted off their shoulders. However, some awards are taxable, and if the correct amount of taxes aren’t paid the Internal Revenue Service can make life inconvenient.

Compensation can be awarded through a settlement, when two parties agree to settle the case out of court, or through a verdict.

Whether compensation is awarded through a verdict or a settlement, the taxes will be the same. However, the type of damages awarded can determine whether or not taxes should be paid.

Different Types of Compensation

There are two types of damages, compensatory and punitive.

Compensatory damages are awarded for actual loses that resulted from proven harm. Typically, compensatory damages are awarded for losses like physical injury, medical expenses, and emotional distress.

On the other hand, punitive damages aren’t awarded to compensate for a loss, but rather as a punishment for cases where the defendants’ behavior was particularly egregious.

So What's Taxable and What's Not?

Punitive damages are rarer than compensatory damages, and because they are not awarded as a loss they are always taxable, according to the IRS.

Compensatory damages are more complicated, and whether or not taxes are paid largely has to do with the original reason the lawsuit was filed.

In personal injury cases, such as those from car accidents, compensatory damages awarded for physical injuries are not taxable. However, for the award to be tax-free the IRS maintains that injuries need to be visible. Therefore, in a case with non-visible injuries, such as sexual harassment or defamation, the IRS will likely want their share of the awarded damages.

This is similar to the IRS’s position on damages awarded for emotional distress. There are two types of damages awarded for emotional distress. The first kind are damages awarded for physical symptoms of emotional distress, like a headache. Damages awarded for this reason are taxable.

The second kind of damages that can be awarded for emotional distress are damages awarded for physical injury or sickness that led to emotional distress. Damages awarded for this are treated like damages awarded for physical injury and are not taxed.

No matter what kind of compensatory damage is received, the reasons why they were awarded will determine their tax status. It is recommended that during settlement negotiations the reasons for why the money is being awarded are also clearly defined. This will help define how to treat the award during tax season, as well as provide a written record in case the IRS comes calling.