It may not seem fair that you can recover compensation from someone, only to find the Internal Revenue Service holding its hand out for a share of the lawsuit proceeds. In fact, the IRS does spare some settlements and awards from taxation. The criteria for differentiating these lawsuits from others is complex, however, so before you omit such money from your tax return, double-check with a professional to make sure you're on the right side of the tax law.
Proceeds as Income
If you have to pay taxes on lawsuit money, there's no special tax rate or percentage for such proceeds. The money counts as regular income. Therefore, the bite the IRS takes might be significant, depending on your other earnings. For example, if you're single and your other taxable income is $90,000, you'd fall into a 28 percent tax bracket as of 2013. If you recover $100,000 in a lawsuit, and if the proceeds fall into one of the categories that are taxable, your income jumps to $190,000. This puts you in a 33 percent tax bracket as of 2013. You could end up giving a big chunk of your lawsuit money to the IRS, depending on what deductions you qualify for.
Legislation passed in 1996 exempts some lawsuit money from taxation, so it's possible you would not have to report the proceeds on your tax return. Exempt proceeds include those associated with personal injury, personal illness or wrongful death. Beyond this, the rules aren't quite as clear cut. Recoveries for emotional distress normally contribute to your income – unless the emotional distress came about because you were hurt. In this case, if you incurred medical expenses because of the distress, reimbursement for this escapes taxation as well. If you're in a car accident, money that reimburses you for damage to your vehicle is tax-free, but only up to the amount of necessary repairs due to the incident. Your lawsuit must result from someone else's negligent or wrongful act.
Punitive and Other Awards
The 1996 law leaves a lot of lawsuit proceeds out in the cold. If your money results from one of these causes, you must include it as income on your tax return. They include punitive damages – a legal term meaning that paying you is intended as punishment to the individual who hurt you. Other taxable awards include those associated with non-physical harm, such as if your rights were infringed on in a discrimination lawsuit, or if someone wronged you monetarily, such as by cheating you out of money due you. Often – but not always – awards for lost wages are taxable. If you had earned the money rather than receiving compensation for not earning it, you would have paid taxes on it, so the IRS often taxes these lost wages.
If your lawsuit money is taxable, the total you must report as income on your tax return includes any portion you pay to your attorney for representing you, as well as any court fees or other lawsuit costs you must pay to prosecute your case if they're deducted from your recovery. The IRS allows you to take a corresponding deduction for these fees, but you must itemize in order to do so and it won't result in a dollar-for-dollar offset of what you must claim as income. Attorney fees and court costs are miscellaneous deductions, which means they're subject to a 2 percent rule. You can only deduct the portion of these expenses that exceed 2 percent of your adjusted gross income. Therefore, if your AGI is $190,000 including your lawsuit money, you can only deduct costs that exceed $3,800.
- San Antonio Business Journal: Lawsuit Settlement Proceeds Can Be Taxing
- Bankrate.com: How Much Tax on a Lawsuit Award?
- WorldWideWeb Tax: Do I Have to Pay Tax on My Legal Settlement or Court Award?
- LawsuitsandSettlements.com: Ever Wonder if Lawsuit Settlements and Verdicts are Taxable?
- Bankrate.com: Tax Brackets
- USLegal: Punitive Damages Law and Legal Definition
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