When Are Taxes Due on Lawsuit Settlements?

Tax-Free Lawsuit Settlements

When the basis of your lawsuit is to obtain compensation for physical illnesses or injuries you suffer, then the amount you receive from a court order or settlement agreement for those injuries is not subject to income tax. However, if in prior tax years you claimed a medical expense deduction related to these injuries, then you need to include those amounts in your taxable income when you receive the settlement. For example, if you take a $5,000 deduction in 2010 for doctor bills related to a broken arm caused by a car accident, and in 2011 you receive a $100,000 award as compensation for your injury, then you must include $5,000 of it in your 2011 taxable income. However, the $95,000 balance remains tax-free.

As part of your settlement or legal award, you may receive a payment in the form of punitive damages. Punitive damages differ from the compensation you receive for an injury in that the sole purpose is to punish the defendant and deter similar behavior in the future. Any portion of the award you receive that is punitive is fully taxable on your return. In addition, courts sometimes increase your total award as interest if a significant amount of time passes between filing your lawsuit and obtaining a settlement. Any award that is the result of interest charges is also fully taxable. You must report both types of awards on your tax return in the year you receive payment.

Although the emotional injury may be just as severe as the physical one you suffer, the IRS doesn't treat both types of settlements the same. Unfortunately, any award you receive for emotional distress or mental anguish is fully taxable on your tax return in the year you receive it. However, if you pay out-of-pocket expenses to visit psychologists, therapists or any other mental health professionals, you can reduce the taxable amount by your medical costs. However, you can only reduce the award if you don't claim a medical deduction for the same expenses.

Since your physical injury awards are tax-free, there is no need to disclose your payments on a tax return. However, when you fill out your Form 1040 at the end of the year, you must include all punitive and emotional distress awards on the "other income" line of the return. The interest, however, you report just like the bank interest you earn from financial institutions during the year. And if the total interest you receive from all sources exceeds $1,500, then you need to report more details on a Schedule B attachment to your 1040.