I know that you expect to receive money from a lawsuit or settlement because of an injury. I also know that the last thing you want to do is pay taxes on this settlement.
And for once, the tax law helps you: there’s a generous tax exclusion available for awards and settlements in injury lawsuits.
However, you must receive the money due to “physical injury or illness” to qualify for tax-free treatment.
Physical Injury or Illness
If a legal action or settlement has its origin in a physical injury or illness, then you can exclude from income all the damage awards that flow from that action, such as
- pain and suffering,
- lost wages or income,
- medical expenses,
- loss of consortium (sexual relations), and
- attorney’s fees and court costs.
Four Exceptions
- Punitive damages. You must always include punitive damages as income, even if they are awarded due to physical injury or illness.
- Prior medical deductions. If a damage award reimburses a previously deducted medical expense, then you must include in income that amount, but only to the extent you received a tax benefit from the deduction in the tax year you claimed the deduction.
- Compensation for a voluntary act. If you receive a payment for pain and suffering from the voluntary performance of a contract, you can’t exclude that income.
- Interest. Interest paid on an award, even if allocable to an excluded amount, is taxable.
Documentation Is Key
The best documentation to claim the exclusion from taxable income is a court document or settlement agreement that specifically allocates your award between compensatory and punitive damages.
Minimize Your Taxes
Consider these tips to minimize your tax burden:
- Be sure the court documents or settlement agreements allocate dollar amounts or percentages between compensatory and punitive damages.
- Try to minimize the amount of the award allocated to punitive damages.
