Whether or not your settlement or award is taxable can be complicated and is determined by the type of damages for which you are receiving compensation.
Section 104(a)(2) of the Internal Revenue Code (IRC) states “the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness” will be excluded from gross income tax. This a very elaborate way of saying that any compensation you receive because of your personal physical injury will not be taxed. This is because money awarded for a personal injury is meant to “make one whole” again, thus it is not income and is not taxable.
Damages that cannot be taxed in most cases include medical expenses and property damage. Pain, suffering, and mental anguish are technically forms of personal injury and won’t be taxed if you can prove that your emotional distress resulted from a physical injury. In contrast, damages recovered from cases that do not involve physical injury – such as defamation – usually are taxed. Also note that in circumstances when recovery for property damage exceeds the monetary value of said property, the amount awarded in excess of the property’s value will be deemed taxable.
In general, any form of compensation that is not directly related to your physical injury will be taxed. Lost wages will be taxed because they are based on income and would have been taxed if they had been earned in the normal course of your job. Punitive damages were not taxed until 1996, when the Supreme Court ruled that they are taxable because punitive damages are used to punish the defendant rather than to compensate the plaintiff for his or her loss.
Awards or settlements of claims not involving personal injury or property damage typically are taxable. In some cases, you can structure the settlement agreement to allocate more money to non-taxable categories. This is all part of the negotiation and where an experienced attorney can be a big help.
To learn more information on what settlements and awards may be taxable in your case, consult with an experienced lawyer and your accountant.