You Win a Lawsuit. Do You Owe Taxes?

Here are some situations where you would owe taxes, and some where you wouldn’t.

Better Investing

Some types of court awards are treated as taxable income by the federal government, while others aren’t.

The rules are laid out in IRS Publication 525 under “Other Income,” but MarketWatch took a stab at sorting them out. Here’s a breakdown of what the site said is and isn’t taxable:

You don’t owe taxes on:

  • Compensation for physical injury or sickness.
  • Compensation for emotional distress from physical injury because it’s considered part of the injury.
  • Amounts paid for lost wages — even though they would’ve been taxed if you’d earned them normally.
  • Amounts received for medical expenses. However, if you claimed a medical expense as a tax deduction and it is later reimbursed, you’re double dipping. In that case, you have to report the amount you deducted as income for the tax year in which you receive the court award, MarketWatch says.

You owe taxes on:

  • Any interest included in an injury/sickness award or settlement.
  • Compensation for emotional distress not caused by physical injury.
  • Payments for legal injuries (such as harassment, discrimination or libel).
  • Punitive damage awards. However, there is an exception. It applies “to punitive damages paid in civil wrongful death actions when applicable state law only allows punitive damages in such cases,” MarketWatch says.

Curious about deducting attorney’s fees? The MarketWatch article has a whole section devoted to explaining the rules on that, but be warned that it’s more confusing than the rest and likely to cause (taxable) “emotional distress.”

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