Taxability of Lawsuit Settlements
Lawsuits can settle immediately after a complaint is filed or several years into the litigation process on the eve of trial, or even during the course of a trial. Most cases will settle before a final resolution is determined by a judge or jury. Settlements generally offer a more favorable resolution than trial for several reasons: (1) both parties avoid the risk of loss at trial, (2) both parties avoid the considerable costs, time, and efforts involved in further litigation and trial, and (3) both parties avoid protracted appeals.
Both parties in a suit seeking monetary damages should consider tax implications in agreeing upon a settlement. This is true for defendants (the party who is being sued) and plaintiffs (the party who filed the lawsuit) since the defendant may need to make tax deductions prior to disbursement to the plaintiff and/or a plaintiff may need to include some types of settlement proceeds as taxable income. Further, a defendant may need to issue a 1099 to the plaintiff along with the disbursement of settlement funds. These determinations are highly fact-sensitive and every party should consult their own CPA or other tax professional who would be most familiar with each parties’ particular situation.
Generally, settlement money received for a personal physical injury is not taxable. (There are exceptions, but this is the general rule.) However, it is important to take into consideration that the settlement amounts may be subject to reimbursement to Medicaid/Medicare or medical insurance. Indeed, the Social Security Act requires that Medicare payments be reimbursed by a subsequent lawsuit recovery, such as a settlement or award.
If a plaintiff receives money to compensate damages of emotional distress or mental anguish which originates from a personal physical injury, that amount is also typically not taxable as income. However, if a plaintiff receives damages for emotional distress or mental anguish which originates from some other source (not physical injury) then the recover may need to be included as taxable income at least in part.
If the lawsuit is an employment related lawsuit (such as a whistleblower claim, wrongful termination claim, or discrimination claim) a plaintiff is generally seeking damages in the form of lost wages. A settlement recovery for lost wages is subject to taxes in the same way that wages are subject to taxes. The settlement income is treated just like it would be as normal employment income (since that is, in fact, what the plaintiff is recovering). Thus, settlement proceeds from an employment litigation in the form of lost wages are likely subject to social security taxes, Medicare taxes, employment tax withholding, etc. While this tends to be a significant tax liability, there is a logical basis for it. If the employee was not “wrongfully terminated,” the employee would have received wages which were taxed in that very same manner. The point of a wrongful termination lawsuit is to put the employee in the position she would have been had she not been wrongfully terminated. Therefore, if taxes were not taken out, the plaintiff would receive more than what she would have if she had never been terminated at all, which could be considered a windfall to the plaintiff.
Also, punitive damages are almost always taxable and should be reported as “other income.” However, settlements do not often designate payments as punitive damages. Settlements may allocate payments for multiple types of damages: such as lost pay, emotional distress, and attorneys’ fees. “Generally, the IRS will not disturb an allocation if it is consistent with the substance of the settled claims.” IRS Publication 4345.
Again, the taxability of settlement proceeds are often fact-sensitive and require a full review of a party’s situation. McLaughlin & Nardi, LLC’s attorneys are experienced with various types of litigations which result in varying types of damages and can advise clients on important considerations regarding settlements. To learn more about what we may be able to do to help, please visit our website, or contact one of our New Jersey lawyers by e-mail or telephone at (973) 890-0004.