Individuals who receive settlements or awards in certain types of cases are often confused about how the proceeds are to be treated for tax purposes.  The Internal Revenue Service (IRS) recognizes that receipt of monies in personal injury or other types of plaintiffs’ actions may create new tax issues for some individuals.

Generally, settlements in actions for personal injury are non-taxable.  If the settlement is to compensate for physical injury or sickness and the plaintiff did not take an itemized deduction for medical expenses related to the injury or disease in prior years, the full amount of the settlement is non-taxable.  However, if related medical expenses were deducted, the tax benefit amount is taxable and should be reported as “other income” on Form 1040. 

Not all plaintiffs litigation is treated the same way.  For example, awards in Employment Discrimination matters or cases involving injury to reputation are taxable.  Some portion of such an award might be taxed as wages with deductions for employment taxes, such as FICA, with the balance taxed as income.  This is also true of awards specifically for emotional distress and mental anguish.  With regard to the latter, the amounts are taxable to the extent it exceeds the amount of medical costs specifically targeted for treatment of emotional distress or mental anguish, not previously deducted.  Finally, punitive damage awards, given to punish a defendant for willful or wanton conduct, are taxable in all cases.  This is true even if the primary award was made in a case for physical injuries.

Tax issues may also arise in property damage matters.  Loss of use or loss in value of property settlements and awards may result in taxable income if the amount involved exceeds the basis in the property.  When settlements in these types of property cases exceed the adjusted basis in the property, the gain is treated as a gain on a capital asset and should be reported accordingly.

Finally, interest awarded as part of a recovery is generally taxable as interest income.  Thus,  if pre- or post-judgment interest is tacked on to a jury award following trial, the amount of the interest earned should be reported. 

The way the IRS will treat the elements of any settlement are usually controlled by how they are referred to in the Settlement Agreement.  Thus, before signing any agreements relating to the settlement of these types of cases, it would be wise to consult with a tax professional.