The general rule regarding the taxation of amounts received in the resolution of lawsuits and other legal remedies is section 61 of the Internal Revenue Code (IRC). This section states that all income is taxable from any derivative source, unless they are exempt by another section of the code. Some judgments and settlements include compensation for punitive damages against the defendant. These damages can provide substantial payment to the plaintiff.
All compensation for punitive damages is taxable, which can result in high taxes. 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. The 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 the emotional distress cause the 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 the money from the physical injury settlement has not been taxable. Compensation for emotional distress is not taxed only if it originated as a result of a personal physical injury or physical illness. Courts have distinguished between signs of emotional distress and symptoms of emotional distress.
A symptom is the “subjective evidence” of a patient's illness. Emotional distress, on the other hand, can include physical symptoms, such as stomach pain, headaches, and stomach disorders, but are generally not considered physical injury or physical illness. On the contrary, a sign is evidence perceptible to the examining physician. In some circumstances, a court may award punitive damages.
Courts award these damages as a form of punishment to those found responsible for the lawsuit. Courts generally award punitive compensation when the defendant's actions involve outrageous behavior, such as fraud, malice, recklessness, or total disregard for the rights and interests of the plaintiff. They are not awarded as compensation for the losses of the injured party and are independent of compensatory losses. Punitive damages are generally taxable; however, they depend on the state.
For example, personal injury lawsuit settlements, including punitive damages, are not subject to taxation under Pennsylvania personal income tax law. Attorneys fees are another complex area when it comes to the taxation of litigation settlements. If your lawyer represents you in a personal injury lawsuit with a contingency fee, you can pay taxes on 100 percent of the money you and your lawyer recover. This is true even if the defendant pays the contingency fee directly to their personal injury attorney.
If your settlement isn't taxable, such as a settlement resulting from injuries sustained in a car accident, you shouldn't face any tax problems. Banks, the Supreme Court of the United States, ruled that the plaintiff's taxable income generally amounts to 100 percent of his settlement. This is the case even if your lawyers get their share. Also, in some cases, you can't deduct legal fees from your tax base.
The tax language used in a settlement agreement is not binding on the IRS or on the courts in subsequent tax disputes, but the document should be as specific as possible about taxes. Most legal disputes involve complicated scenarios and multiple related issues. Even if your dispute relates to the main issue, the agreement may involve more than one consideration. When the parties agree to tax treatment, even though it is not binding, the IRS considers the parties' intention when determining whether to exclude an agreement from the tax.
If the settlement agreement does not address taxes, the IRS will analyze the payer's intention to determine the tax status of the settlement payments. In some cases, it is possible to distribute damages between several claims. For example, some damages may be due to physical injury or illness, which are not subject to taxation. Others may pay for emotional distress, which is generally subject to taxation.
Consider the potential tax implications when negotiating a settlement agreement and before signing it. Once you've signed the agreement, you can't change it. During a lawsuit, most people's attention is primarily focused on the outcome and amount of compensation awarded. To ease an early recovery, people may not consider any taxes you may have to pay on the amount of the settlement.
By now, you've probably already taken on countless challenges, such as enduring a painful recovery and financial losses. You and your attorney have long fought to obtain compensation that covers the full cost of your injuries. After dealing with physical and financial recovery from an injury, the last thing you want is to talk to the IRS. The goal is for you to withhold as much of your settlement amount as possible to help you recover.
You must pay taxes on income from legal agreements because they are considered part of your annual gross income. However, there are exceptions to this rule, especially in personal injury cases. This is important to know because a settlement agreement must be carefully drafted taking into account tax payments. Taxes on liquidations can vary widely.
The IRS states that the money received in a lawsuit must be taxed based on its purpose. . .