IRS RULES ON HOW SETTLEMENTS ARE TAXED
December 27, 2019 - Douglas Myser
IRS rules on how settlements are taxed. Taxes depend on the "origin of claim". Taxes are based on the origin of your claim. IF you get laid off at work and sue seeking wages, you will be taxed as wages, and probably some pay on a Form 1099 for emotional distress. But if you sue for damage to your condo by a negligent building contractor, your damages may not be income. You may be able to treat the recovery as a reduction in your purchase price of the condo. The rules are full of exceptions and nuances, so be careful, how settlement awards are taxed, especially post tax reform. IRS rules on how settlements are taxed.
Recoveries for physical injuries and physical sickness are tax free, but symptoms of emotional distress are not physical. If you sue for physical injuries, damages are tax free. Before 1996 all personal damages were tax free, so emotional distress and defamation produced tax free recoveries. But since 1996, your injury must be "physical". If you sue for intentional infliction of emotional distress, your recovery is taxed. Physical symptoms of emotional distress is taxed, but physical injuries or sickness is not. The rules can make some tax cases chicken or eff, with many judgement calls.
Allocating damages can save taxes. Most legal disputes involves multiple issues. You might claim that the defendant kept your laptop, frittered away your trust fund, underpaid you, failed to reimburse you for a business trip or other items. Even if your dispute relates to one course of conduct, there's a good chance the total settlement involves several types of consideration. It is best for plaintiff and defendant to agree on tax treatment. Such agreements are not binding on the IRS or the courts in later tax disputes, but they are usually not ignored by the IRS. Punitive damages and interest are always taxable. Take that into account when considering whether to settle or go to court.
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