Whether it’s an out-of-court settlement or an award from a judge or jury, plaintiffs do not have to pay taxes on non-pecuniary damages. Similarly, any compensation received for hospital expenses, medications and interest generated by the award by the end date of the court decision are also non-taxable.
The general rule of taxability for amounts received from settlement of lawsuits and other legal remedies is Internal Revenue Code (IRC) Section 61 that states all income is taxable from whatever source derived, unless exempted by another section of the code.
How are legal damages taxed?
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.
What are the tax implications of a lawsuit?
Employment-related lawsuits may arise from wrongful discharge or failure to honor contract obligations. Damages received to compensate for economic loss, for example lost wages, business income and benefits, are not excludable form gross income unless a personal physical injury caused such loss.
What are the tax implications of discrimination suits?
Discrimination suits for age, race, gender, religion, or disability can generate compensatory, contractual and punitive awards, none of which are excludible under IRC Section104 (a) (2). As a general rule, dismissal pay, severance pay, or other payments for involuntary termination of employment are wages for federal employment tax purposes.
What is included in gross income under IRC Section 61?
IRC Section 61 explains that all amounts from any source are included in gross income unless a specific exception exists. For damages, the two most common exceptions are amounts paid for certain discrimination claims and amounts paid on account of physical injury.
How are awards and settlements classified for tax purposes?
Awards and settlements can be divided into two distinct groups to determine whether the payments are taxable or non-taxable. The first group includes claims relating to physical injuries, and the second group is for claims relating to non-physical injuries. Within these two groups, the claims usually fall into three categories:
