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Are Lawsuit Settlements Taxable?

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Missouri personal injury Specialists

Are lawsuit settlements taxable? Buchanan, Williams & O’Brien can shed light on tax obligations. Call us today for more information.

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The Tax Implications of Your Settlement

Lawsuits can cause financial and emotional distress for the parties involved. While receiving a settlement can offer relief, receiving a large amount of money raises new questions. In particular, you may be wondering about paying taxes. 

Whether your settlement is considered taxable depends on the nature of the settlement. In general, a personal injury settlement is not taxable. However, you may owe taxes on some settlement proceeds not related to personal physical injuries or for expenses you previously deducted on your tax returns.

At Buchanan, Williams & O’Brien, we have extensive experience with personal injury settlements. We not only assist our clients through the settlement process, but help our clients comply with Internal Revenue Service (IRS) guidelines.

Basics of Lawsuit Settlements and Taxes

What Is a Settlement?

A settlement is an agreement to resolve a legal dispute between two parties. It usually involves one party paying a sum of money to another in exchange for that party agreeing not to pursue, or to stop pursuing, any legal claims.

Legal settlements can take various forms. Ultimately, all of these agreements dictate both how settlement money will be paid and the compensation that will be received for each individual claim. A personal injury case settlement, for instance, may include compensation for medical expenses, lost wages, and pain and suffering. Settlement money can be paid in a lump-sum payment or over time in a structured settlement.

What Are the General Tax Implications?

All settlement proceeds are not equal under the Internal Revenue Code. The IRS provides various guidelines regarding tax implications of settlements, distinguishing between taxable and non-taxable settlement amounts. Seeking advice from a qualified tax professional or attorney is essential for personalized guidance.

The Tax Implications of Your Settlement

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Are Personal Injury Settlements Taxable?

In general, the IRS will not tax settlement money received for physical injuries or physical sickness unless you previously deducted medical costs related to that physical injury. Emotional distress damages arising from a physical injury or physical sickness is treated like payments for physical injury. If not related to a physical injury, a settlement payment for emotional distress is considered income.

Your personal injury case may also include claims for non-physical injuries. Any settlement proceeds related to the following can be taxed:

  • Lost wages or lost profits: Damages for lost wages are considered taxable wages and are subject to normal income taxes. Similarly, an award for lost profits is considered business income.
  • Loss in value of property: Loss in value of property may be considered income and subject to tax if the settlement amounts paid exceed the property’s adjusted basis.
  • Interest: Any interest paid on a settlement is generally considered taxable.
  • Attorney fees: Legal fees paid can also affect your taxable amount. In some cases, an award of attorneys’ fees may be considered income.
Are Personal Injury Settlements Taxable

Confused about personal injury in Missouri? We are here to answer your questions.

Other Types of Settlements

Unlike a personal injury settlement, other common types of legal settlements are likely subject to tax.

Employment Settlements

Settlements for employment discrimination claims or unpaid wages can have varying tax implications. Payments for wages and salary, including severance pay, are taxable as ordinary income. These amounts are subject to federal income tax, Medicare, and Social Security tax.

Compensation for back pay and front pay are also considered taxable income. Additionally, any damages awarded for emotional distress or punitive damages are taxable.

Property Damage Settlements

Property damage settlements have different tax consequences. Their implications depend on the nature of the damages and underlying legal principles.

Compensatory damages are generally non-taxable. These damages are meant to compensate for the loss or decrease in value of the property. For example, if the property damage settlement is an insurance reimbursement, it is not taxable. However, if the property settlement exceeds the adjusted basis for the property, it will be considered income.

Punitive Damages

The Internal Revenue Code classifies punitive damages as taxable income. While punitive damages ultimately compensate the plaintiff, their purpose is to punish the defendant for their behavior and to deter others from similar actions.

Are There State-Specific Tax Rules and Considerations?

Most states follow federal guidelines on the taxability of lawsuit settlements. However, it is important to understand the implications of your state’s tax code on your legal settlement.

  • Compensatory damages: Most states, including Missouri, do not tax compensatory damages

  •  Punitive damages: Some states consider punitive damages to be taxable income.

  • Interest: State rules can vary on the taxation of interest earned on lawsuit judgments.

  • Legal fees: The treatment of an award of attorneys’ fees can vary. While they are often not taxable, some states may have specific rules or exceptions.

  • Structured settlements: States might have differing rules on the tax treatment of structured settlements. Some states follow federal guidelines, while others have their own regulations.

  • Income tax rate: Your state’s income tax rate can influence the tax burden on lawsuit settlements. States with higher income tax rates may have higher tax liability for settlements.

  • Deductions: States may offer unique exemptions or deductions that can affect the taxable amount.

  • Legal precedent: State court decisions can influence the taxes due on a legal settlement. Precedents set by the courts play a role in shaping the tax landscape for settlements.

Given the variability in tax laws among the states, involving an attorney in your settlement negotiations is advisable. The experienced attorneys at Buchanan, Williams & O’Brien can offer guidance on how federal and Missouri tax laws will affect your tax obligations.

What Tax Forms and Documents Are Required for Reporting My Settlement?

The documents and tax forms required for reporting income derived from a legal settlement will vary. In general, you will be required to file the following:

  • W-2 or 1099: Form W-2 or Form 1099 to report your taxable gross income. The type of form depends on the nature of the income, such as wages or non-employee compensation.

  • Copy of settlement agreement: A settlement agreement detailing the terms and conditions of the settlement. If you have a structured settlement, this should outline the schedule of payments and their terms. Other documents like medical bills, repair estimates, or evidence of financial losses may be needed as well.

  • Copy of court order: Official court judgments or orders detailing the settlement amount and allocation of damages. 

  • Form 1040: Tax forms to report other income like capital gains and losses.

  • State tax return: State-specific forms, like state income taxes.

Best Practices for Reporting a Settlement

Tax planning can help you receive any tax benefits available and avoid paying additional taxes or penalties. If you have received, or are expecting to receive, a legal settlement you need to:

  • Consult a tax professional.

  • Retain and verify critical documents relating to your legal claims and settlement.

  • Report all taxable income.

  • Be aware of exemptions and deductions.

  • Comply with state-specific tax laws.

  • Document attorneys’ fees related to the settlement.

The Team at Buchanan, Williams & O’Brien, P.C. Can Help

Professional legal counsel is vital for navigating lawsuit settlements and tax implications. Let the experienced personal injury attorneys at Buchanan, Williams & O’Brien help.

We offer personalized guidance to help you make informed decisions throughout settlement negotiations. Our attorneys can make a significant difference in the outcome of your lawsuit settlement. Additionally, we will ensure compliance with applicable tax laws.

Every lawsuit settlement is distinct. We offer tailored advice and assistance with your personal injury case settlement. From slip and fall claims to the truck accident settlement process in Missouri, we help our clients understand every aspect of their settlement.

Contact us today to schedule a consultation.

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