Settlements and judgments may be tax-free based on the circumstances of your case. The money is often seen as compensation for the taxpayer's loss rather than being computed into gross income for the year and taxed. However, money received that isn't directly compensating for a loss may be taxable. Our Pasquesi Sheppard team in Lake Forest, Illinois, invites you to learn more about how settlements are handled regarding tax time.
What Is Generally Exempt From Being Taxed as Income?
Settlements or judgments that cover losses such as property damage, bodily injury, or pain and suffering aren't taxable because they're meant to compensate for losses. This includes several types of losses, such as:
- Physical injuries and sickness.
- Medical expenses, including surgeries, physical therapy, and medications.
- Physical disfigurement or pain and suffering that are considered non-economic damages.
- Emotional distress caused by the incident and its aftermath.
What Settlement Types May Have Tax Implications?
Damages not directly related to a loss, such as medical expenses or pain and suffering, may be taxable. Punitive damages, or additional money provided to the victim of a personal injury or other loss, are given when the responsible party is grossly negligent or demonstrates egregious behavior. Punitive damages are designed to punish the responsible party and prevent them from committing the same actions or inactions in the future. Punitive damages also set an example for others to dissuade certain types of conduct.
Punitive damages apply after other damages are already covered. Constitutionally, they can be no more than 10 times the initial award. States may also cap the amounts. Other types of settlements may be taxable depending on the circumstances, so it's best to consult with a tax expert to ensure you don't incur penalties. Each case has unique circumstances that require careful examination.
How Do I Determine the Tax Implications?
The settlement or verdict paperwork can help determine which portion of a settlement may be taxable. A personal injury attorney can help outline which amount is taxable or not. It's best to consult a skilled tax professional because IRS penalties may apply for those who try to allocate taxable settlement dollars to the nontaxable portion improperly. It's essential to comply with state and federal tax laws when handling a settlement.
For those who itemize, claimed medical expenses related to the accident must be recognized if they were compensated from the settlement or judgment. This typically would apply to those who itemize the medical expenses one year but aren't paid until the following year. Tax laws cover lump-sum and structured settlements that provide periodic payments for a specified time.
How Common Are Taxable Damages?
Most damages are compensatory and not taxable, but sometimes punitive damages are assessed and given to the recipient of the settlement or judgment. Most cases are resolved before a jury trial, with national statistics showing that over 90% of lawsuits are settled before they go to a trial.
Punitive damages are rare in personal injury cases but might be a factor where there is conduct that was fraudulent, intentional, or willfully or wantonly committed by the defendant. Negligence alone isn't an indicator that punitive damages are appropriate in a settlement or judgment.
How Does Illinois Handle State Taxes for Settlements?
Illinois treats the taxability of settlements and judgments as the IRS does, so Illinois and federal tax implications are the same. Illinois has a flat tax of 4.95% for individual filers. You may receive a bill for taxes if the settlement or judgment meets the criteria for 1099 income.
How Do I Minimize My Tax Liability?
Be proactive in declaring settlement amounts and seeking exemptions from state and local taxes. After winning a settlement or judgment, a significant tax bill can be unpleasant and challenging. The Internal Revenue Code, Section 61, states that any payments from any source are considered part of your gross income unless covered under a specific exemption. Make sure you understand your settlement's tax status before spending it so that you reserve a portion to cover taxes, if applicable.
You may need to prove bodily harm or other damages directly compensated through an award. Emotional distress may be taxable, but it isn't taxable if an injury or medical problem causes it. Be mindful of deductions you may have itemized for medical expenses because you can only be exempt from taxes once. If you claimed medical deductions for an injury in the previous year, you may be subject to taxation of a portion of a settlement or judgment for that injury.
Punitive damages, which should be specified in court documents, are taxable because they're designed to punish the responsible party and aren't directly related to a financial loss you may have incurred. Back pay from an employer is also likely taxable because it's paying you the money you should have earned (and been taxed on) in the first place. Interest income on a settlement may be taxable because it's in addition to the money intended to compensate you for losses.
Regardless of taxability, reporting any settlement income to the IRS is essential, even if part or all of it is exempt from tax. There are four main ways you can minimize your tax exposure for settlements:
- Negotiate the taxable amount of a settlement or the amount that's sent to you on Form 1099 from the defendant. This negotiation is between the attorneys and typically is beneficial for both parties in a case.
- You can treat taxable settlements as capital gains and obtain a lower tax rate depending on your situation.
- Structured settlements paid over time help you maintain a lower tax bracket than if you receive a lump-sum payment, meaning there is less tax liability each year.
- Ensure the damages are appropriately allocated because the portion directed toward personal injury and other nontaxable factors is adjustable. The net award may be reduced in such a negotiation, but you may pocket more money overall if taxes are reduced.
Our Team Can Help
Our financial planning and consulting experts are ready to help you analyze the tax implications of a settlement or judgment by helping you make the most profitable financial decisions. We'll help you with key services, including tax planning, tax preparation, estate planning, and accounting. If you have questions about capital gains taxes, please contact us via our secure online form or call 847-234-5000. We'll be happy to ensure you take the proper steps to allow you to minimize your tax burden when it comes to handling a settlement or judgment.
Tax Return - 1040 by 401(K) 2012 is licensed with CC BY-SA 2.0