Do You Pay Taxes on Lawsuit Settlement Money?

People file lawsuits for a wide variety of reasons. Perhaps you have been injured in an automobile or work-related accident and the responsible party refuses to pay. Maybe you suffered wrongful termination and you want back-pay, as well as punitive damages. Or it could be that you are a contractor who completed work and never got paid for it. In short, lawsuits are a way for a person who has been wronged in some way to receive restitution. And since you’re the one who has suffered, you might think that you’d get the entirety of any settlement resulting from a lawsuit. Unfortunately, this may not necessarily be true. Aside from paying off your lawyers, you could also be on the hook for paying taxes on the money you win from a settlement. And if it’s a large sum of money, you might even get bumped into a higher tax bracket and end up paying a larger percentage in income tax than you normally would. It sounds like a bum deal, but you need to understand what you could end up owing when you launch a lawsuit in search of a monetary settlement.

In truth, there are certain situations whereby you may end up being able to keep all of the money that is awarded to you in a lawsuit, but the laws regarding these occurrences are very specific. The only time you will not have to pay taxes on money received from a settlement is if the damages awarded are compensation for physical injury or illness. The idea here is that you are granted the settlement in order to pay medical bills, current and future, for the injury or illness you’ve suffered. So in a sense, you are not getting any kind of personal gain from the money since it is, in essence, slated to pay bills related to the physical harm you suffered, bills that you wouldn’t have if not for the damage caused by the responsible party. But pretty much everything else is considered taxable, except for special circumstances.

Emotional distress, for example, is not generally considered to be physical, but insomuch as it is caused by a physical injury or illness claimed in a lawsuit, any monies awarded for emotional distress in addition to the settlement for physical harm may be considered tax-free. If, however, you claim emotional distress due to sexual harassment or discrimination in the workplace, cases where there was no physical injury or illness, the settlement will be subject to taxation when you file your annual income tax return. Of course, in many cases you can deduct the cost of your attorney and court fees if you end up owing the IRS for money received in a settlement, so that you don’t have to pay taxes on money that is virtually going to pay for your legal battle.

But you can’t deduct more than the amount awarded. So if you took out quick lawsuit loans in order to pay your attorneys, depending on the money from a settlement to pay them back, you will not only find yourself on the hook to repay overages yourself, but you also won’t receive any additional tax break for legal fees owed beyond what the settlement covers. The long and short of it is that unless you have suffered physical harm, chances are good you’ll end up owing the government money on any settlement you receive in the course of a lawsuit. So you might want to keep that in mind before you hire an attorney and set the legal gears in motion.

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