How to Report Legal Settlements on Your Taxes

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If you have recently settled a lawsuit outside of the courts, whether personal or as a business, the government may consider your compensation as taxable income, and so you must report it on your tax return. Omitting or leaving out income from legal settlements can be a serious offense, so you want to make sure you are on the right side of the IRS after a settlement or damage award. The experienced claims attorneys of Kelley/Uustal can help you navigate the complicated claims and settlements procedures and help you understand how to report your settlement for tax purposes.

Here are some things you should before filing your taxes after a settlement or award.

IRS Guidelines

The IRS lists many types of settlement money as taxable income, including recovery of lost wages, damages for breach of contract, and punitive damages. While some sub-categories are broken down below, a general rule of thumb to follow is if the settlement money replaces an expected income, then you must report it.

Source of the Claim

The nature of the original claim in the settlement will determine whether the damage money is taxable. For example, if a person were to sue for lost wages, the recovery amount in lost wages would be a replacement for expected income. Therefore, the money would be taxable.

The IRS categorizes settlement awards into two different groups. The first group includes physical injury claims. Claims from any bodily injuries such as broken bones, brain damage, or severed limbs would be physical injuries. The second group comprises cases from non-physical injuries including sexual harassment, discrimination, divorce, or other non-physical claims.

Both of the physical and non-physical claims then typically fall into three different sub-groups:

  • Damages from a physical (or non-physical) injury. The IRS considers these types of settlement figures as non-taxable.
  • Emotional stress from a non-physical injury. If distress occurs because of a non-physical injury, damage money is typically taxable as reportable income.
  • Emotional stress from a physical injury. This type of settlement money would be non-taxable.
  • Punitive damages from the physical (or non-physical) injury. These types of recovered costs are always taxable income to the IRS.

Explicitly State the Purpose of Settlement Money

Any settlement money should clearly state the reason for the damages you are claiming. Your claim should have specific language that details the amounts paid for lost wages, physical injury damages, attorney fees, and any other collected damages or other fees.

Settlements that do not include reasons for payments are likely to be determined using the source of the claim.

Settlements with W2 and 1099-MISC Forms

The IRS requires the paying party in a settlement to send the person that settled a Tax Form 1099-MISC. The payer will fill out this form. Box 3, or “other income,” includes the money received in the settlement. Lawyer fees will not reduce this amount.

In most cases, all damages reported in Box 3 are taxable.

Any collected damages are considered as wages if the person that settled received an award for back-pay. The back-pay amount would then be reported on a Form W-2 rather than on a Form 1099-MISC.

Getting Professional Advice

For anyone collecting in a legal settlement, expect tax consequences if the recovered money compensated for wages or pay. Working with a professional tax advisor, and an experienced lawyer, like the Florida attorneys at Kelley Uustal, can help word your settlement in a way that will protect you and save you money during tax season.