It’s natural to wonder, “How will my lawsuit settlement be taxed?” Indeed, this is a question that should be addressed before even deciding to settle a personal-injury lawsuit in the first place, because the tax treatment of lawsuit settlements are treated differently, depending on whether the moneys are intended to reimburse a plaintiff for bodily injuries, damage to personal property, lost wages, etc. The last thing you want is to receive a settlement to make you and your loved ones whole, and then to have the Internal Revenue Service (IRS) come take much of it away.
Damage to Property (Real Estate or Personal Property)
An example of damage to property that could be reimbursed through a lawsuit settlement is in a common automobile collision case. If the settlement is meant to compensate the victim for the car’s lost value, generally that money does not need to be reported as income. Note that if the settlement exceeds the “adjusted basis” of the property—this is more common in a business context—then there will be tax implications, and it would be a good idea to consult with an accountant.
Personal Injury (being Physically Hurt or Physically Sick)
A person who has suffered a personal physical injury—like broken bones, soft-tissue nerve damage, etc.—does not need to pay taxes on settlement money related to that personal injury.
But it’s important to remember that if the injured person has taken an income-tax deduction for the medical expenses in treating the injury, and any part of the settlement is to reimburse the victim for medical expenses, that portion must be declared as income. Again, this only applies where the injured person has taken a tax deduction in a prior year for medical expenses for treating the injury.
Emotional Injury (Emotional Distress or Mental Anguish)
If the emotional injury originates from a personal injury—like being physically hurt or sick—then these settlement funds are treated the same as those paid for physical injuries (not taxable). If the emotional injury does not originate from a physical personal injury, then those settlement proceeds are taxable (though the injured person still may deduct the cost of the medical treatment for the emotional distress).
Lost Earnings (Lost Wages, Lost Salary, or Lost Employment Benefits)
If the lawsuit is employment-related (perhaps for racial discrimination, sexual harassment, age discrimination, wrongful termination, etc.), then the portion for lost wages is taxable, and must be reported as wage income and be taxed.
If you receive interest income on a monetary settlement, the IRS treats that as taxable “interest income,” and you must report it on your tax returns.
Generally, a jury may award punitive damages where there is substantial evidence establishing that the wrongdoer’s conduct was outrageous and based on an evil motive or reckless indifference to the rights of others. Although settlements agreements don’t typically earmark any of the settlement funds as “punitive damages,” it’s still worth mentioning.
First, it is necessary to understand that in Missouri, punitive damages are limited to either $500,000 or five times the net amount of the judgment. R.S.Mo. 510.265. (If that seems like it violates basic Constitutional principles, like equal protection and due process, that’s because it does. But unfortunately—for the time being, anyway—the Missouri Supreme Court disagrees.) And the Missouri General Assembly has gone one step further, allowing the judge to reduce the jury’s punitive-damages award (called “remittitur”). R.S.Mo. 510.263. Fortunately, Missouri judges also have the power to increase the punitive damages, too, under the same statute (called “additur”).
Second, it’s also important to understand that the victim/plaintiff still can’t take home all of that money—before even considering taxes. That’s because under R.S.Mo. 537.675, the state gets fifty percent (50%) of the punitive damages, which goes to the Missouri Tort Victims’ Compensation Fund (calculated after attorneys’ fees and expenses are deducted).
Now, after all of those reductions and deductions, whatever punitive damages reach the victim/plaintiff are taxable as “other income” on federal income tax returns. It doesn’t matter if those punitive damages relate to physical injuries, damage to property, or anything else. They are taxable.