When is a Settlement Agreement Taxable?

When is a Settlement Agreement Taxable?

Signs that Your Settlement Agreement is Taxable

The process of living through a lawsuit, no matter the cause of the purpose, is a draining one, taking up much of your time, mental energy, and even resources to pay for your legal representation. But for lawsuits where you end up winning and are awarded a settlement agreement, it can indeed be worthwhile to have the wrong made right and to receive the compensation you feel you’re duly allotted. Yet once the settlement agreement comes in, it’s important not to start spending it right away without considering at least one more critical factor: potential taxes.

While you may want to assume the amount you received is due to you, there are many instances where you will pay taxes on your settlements. And the time to be aware of that is before you do anything with your settlement agreement, not to wait until tax season and find yourself unprepared. So, do you pay taxes on your specific settlement?

Instances where taxes are not collected on settlement agreements

Let’s start by examining what instances you can expect that the IRS does not tax your compensation from a lawsuit. The primary example where you are free from tax obligations is if your settlement agreement pertained to personal injury and was awarded for observable bodily harm. So, any lawsuit that resulted in conjunction with an instance that left you physically harmed is free from a tax burden.

This observable bodily harm can be slightly extended to a few other instances, as well. If you had to seek medical attention (such as therapy or counseling) because of non-physical, purely emotional distress, then those medical costs can be made tax free.

Similarly, if you encountered emotional stress from the result of a physical injury associated with the lawsuit, then the settlement agreement may be omitted from taxable income.

Instances where taxes are collected on settlement agreements

Outside of the observable bodily harm area, most other types of settlement agreements from lawsuits will require you to report the associated funds as taxable income. Settlements stemming from purely emotional distress, improperly lost wages, punitive damages, breach of contract, and other standard lawsuits outside of ones related to physical injury must have their payments all reported as taxable income and appropriately taxed.

Another important note is that sometimes settlement agreements award the winner of the lawsuit funds equal to their legal costs. Regardless of whether the lawsuit was related to physical injury or not, the part of the settlement that goes towards attorney fees is reported as taxable income. And you cannot deduct your legal costs and expenses from any settlement amount before calculating the taxable income. Your legal fees are not eligible for itemized deduction from your taxes.

Note, of course, that the above are all general guidelines, but it all comes down to specific circumstances as with any legal or tax matters. As such, the best approach is to consult an expert on the issue to provide the best advice. The tax experts at Tobin & Collins are here to help. Our tax experts are ready and able to assist you in evaluating your settlement agreement and evaluating what taxes you may owe. Contact us to get started today!