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Do You Need to Pay Taxes on Your Settlement Money?

Do You Need to Pay Taxes on Your Settlement Money?

A sudden windfall of cash comes with its fair share of advantages and disadvantages. It’s important to have a plan in place to help you avoid potential compliance issues down the road.

Are lawsuit settlements taxable? Take a look at this overview to understand how and when you need to claim lawsuit settlements on your taxes.

What is Income?

Most Americans are aware that any form of income they receive is taxable. If you pick up a few freelance assignments, it’s taxable.

If you drive Uber one or two nights a week, it’s taxable. Even babysitters receive income that’s subject to taxation.

But what about the money you get that you didn’t work to earn? Technically, lottery winners didn’t go to work for their winnings so it’s not taxable, right?

Wrong. The IRS considers the money you receive to be either a gift or income. 

There are very distinct ways to define a gift. You receive gifts with no expectation of anything in return.

You show up and someone offers you cash for no reason except the kindness of their heart. This exchange usually happens between spouses, family members, or friends.

A company doesn’t gift employees money because they’re sorry about injuries that happen at work. The money is to cover a setback or compensate for lost time.

A lawsuit is a form of working towards an outcome. 

The employee goes through the process of filing a claim and working with an attorney to supplement income using a settlement. For this reason, employees must pay taxes on settlements as if they were regular income.

Are Lawsuit Settlements Taxable?

There are a few exceptions to the taxation rule. If you seek counseling for your emotional distress following a tragic car accident, your counseling sessions might be reimbursed as part of your settlement.

In fact, all of your medical bills will likely be reimbursed as part of the settlement. These costs are considered expenses and aren’t taxable. Another major exception to the taxation rule is with personal injury cases.

If you win a structured settlement due to personal, physical injury, the IRS won’t tax the money you receive. Keep in mind that the ‘observable bodily harm’ rule means that your injuries have to be visible in order for your award to be considered tax-free.

Here are common situations where your settlement might be taxed by the IRS:

  • Interest charges on compensation
  • Punitive damages
  • Lost wages or lost profits
  • Settlements that involve emotional distress
  • Civil Rights Act cases
  • Patent or copyright infringement
  • Breach of contract
  • Settlement for pension-related suits
  • Attorneys fees and related costs

If any of these items are included in your settlement, there’s a good chance you’ll owe taxes on the amount you receive. 

Navigating your Settlement Money

It’s a good idea to get the advice of a certified public accountant (CPA) to make sure you’re claiming the correct amount from your settlement on your taxes. Are lawsuit settlements taxable?

In most cases, yes. Unless you have a physical injury, you will have a difficult time convincing the IRS you aren’t evading taxes.

Get ahead of the game by meeting with a CPA for a tax planning session as soon as your windfall comes in. For more information and tips, visit our blog for updates. 


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