When Is Money from a Lawsuit or Settlement Tax-Free?

– Awards and judgments for personal physical injuries or physical sickness are tax-free under the tax code.
– Compensatory awards for emotional distress are not treated as physical injuries and are therefore taxable.
– Punitive damages and awards for unlawful discrimination or harassment are also taxable.
– A taxpayer received a settlement of over $327,000 from his former employer in connection with a lawsuit but did not report it on their tax return.
– The IRS determined that the taxpayer owed taxes and penalties of more than $119,000 for not including the settlement payment in their gross income. 1. The Tax Court ruled that a settlement payment for alleged personal injuries was not exempt from gross income because there was no evidence it was paid on account of physical injuries or sickness.
2. A taxpayer’s legal malpractice settlement payment of $125,000 was not excluded from gross income and was subject to taxes and penalties, as it was determined to be for legal malpractice and not for physical injuries.
3. The tax-free income requirements for court awards or out-of-court settlements are strict, and taxpayers are advised to consult with tax professionals regarding the tax implications.

Awarded Money in a Lawsuit or Settlement? It’s Only Tax-Free in Certain Circumstances