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When you find yourself on the receiving end of a lawsuit settlement, it’s only natural to wonder about the tax implications of those funds.
In this article, we aim to shed light on whether you’re required to report these settlement proceeds as part of your taxable income. The determination of whether or not you need to include the settlement proceeds in your income is contingent upon a thorough examination of the specific facts and circumstances surrounding your case.
A settlement payment isn’t always a simple lump sum; it can often consist of various components that have been carefully allocated by the parties involved. For instance, a settlement agreement might divvy up the funds to cover back pay, compensate for emotional distress, or even address attorney fees. Generally, the Internal Revenue Service (IRS) won’t contest these allocations as long as they align with the substance of the claims settled.
It’s worth noting that settlements related to personal physical injuries or physical sickness may have distinct tax considerations,” emphasizes Marietta injury attorney Ramiro Rodriguez, Jr.
Tax Treatment of Different Settlement Components
Here, we break down the tax treatment for different aspects of settlements:
Settlements for Personal Physical Injuries or Sickness:
If you receive a settlement for personal physical injuries or physical sickness and haven’t previously claimed itemized deductions for related medical expenses in prior years, the entire amount is non-taxable. You need not include these settlement proceeds in your income.
However, if you did deduct medical expenses related to the injury or sickness in previous years and received a tax benefit from those deductions, you must include that portion of the settlement in your income. To calculate the taxable amount, you should allocate it on a pro rata basis to each year you paid medical expenses. You can find detailed instructions on how to determine the taxable amount in ‘Recoveries’ in Publication 525. Report the tax benefit amount as ‘Other Income’ on line 21 of Form 1040.
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Emotional Distress or Mental Anguish:
Proceeds received for emotional distress or mental anguish stemming from personal physical injuries or sickness follow the same tax treatment as those received for physical injuries or sickness as mentioned above.
If the proceeds for emotional distress or mental anguish are unrelated to personal physical injuries or sickness, they must be included in your income. However, you can reduce the taxable amount by (1) the amounts paid for medical expenses tied to emotional distress or mental anguish that weren’t previously deducted and (2) previously deducted medical expenses for such distress and anguish that didn’t provide a tax benefit. Attach a statement to your return displaying the entire settlement amount minus related medical costs not previously deducted and medical costs deducted without tax benefit. Report the net taxable amount as ‘Other Income’ on line 21 of Form 1040.
Lost Wages or Lost Profits:
Settlements received in employment-related lawsuits, such as those for unlawful discrimination or involuntary termination, include a portion for lost wages (e.g., severance pay, back pay, front pay). This portion is considered taxable wages and is subject to social security wage base and social security and Medicare tax rates applicable in the year of payment. The payor is responsible for employment tax withholding, and you should report it as ‘Wages, salaries, tips, etc.’ on line 7 of Form 1040.
Settlements for lost profits in your trade or business constitute net earnings subject to self-employment tax. These proceeds are taxable and should be reported as ‘Business income’ on line 12 of Form 1040. Additionally, include them on line 2 of Schedule SE (Form 1040) when calculating self-employment tax. For more information about reporting self-employment income and paying self-employment tax, refer to Publication 334, ‘Tax Guide for Small Business (For Individuals Who Use Schedule C or C-EZ).'”
This breakdown should provide clarity on how different components of settlements are treated for tax purposes, helping individuals navigate their financial obligations when they receive a settlement.