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
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.