Uncle Sam enjoys a good lawsuit settlement or two or three

July 01, 2014 by Eric Linden
Gavel

You fell down some stairs outside Zippo’s Supermart after an employee left a mop right smack dab in the middle of the walkway. Seeking justice and all, you file suit against this retailing behemoth. After a mountain of paperwork, depositions, and some negotiation, they settle. You receive a decent settlement and plan to book a nice vacation to Fiji. Oh, and buy a home for your mother. You may have forgotten one little thing: TAXES. Yes, Uncle Sam loves lawsuit settlements just like plaintiffs do. Before you start spending the money, there are some things you need to know. There is both good news and bad news:

Settlements from a lawsuit that are taxable (the bad news):

• A settlement that replaces taxable income (e.g. , lost wages due to the accident)
• Damages paid for personal injuries that are not physical injuries (e.g. slander, defamation, breach of promise)
• Insurance reimbursement of medical expenses that were deducted in an earlier year (BUT only to the extent of the tax benefit received in the prior year)
• Punitive damages, even for physical injury other than for certain wrongful death claims
• Interest on any award
• Amounts received in settlement of pension rights (and you have no basis in the pension)
• Damages for patent or copyright infringement, breach of contract, or interference with business operations

Settlements from a lawsuit that are NOT taxable (the good news):

• Damages received for physical injury (includes emotional distress)
• Property damage, as long as the payment does not exceed basis (not the cost to replace item)
• Refund of the price paid for goods or service if the expense was not deducted in a prior year
• Damages in cases of nonphysical injury equal to the amount of medical expenses for treatment of emotional distress
• Insurance reimbursements of medical expenses not previously deducted on a tax return

The tax ramifications for lawsuit settlements can be tricky to understand, and we highly recommend you consult a qualified tax professional if trying to determine how much of it you need to set aside so Uncle Sam has funds for new highways and drones for counter surveillance.

Tags: IRS, tax planning
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