After getting a lawsuit settlement, you may wonder if you owe taxes on it. The tax consequences of a lawsuit settlement in California can be complicated and the rules about taxes depend on the type of claim.
According to thetaxadviser.com, the Internal Revenue Code says that most lawsuit settlements are taxable income unless they are specifically exempt. Although some settlements might be completely tax-free, others could be partially or fully taxable under both state and federal law.
We’ll help you understand what settlements are taxable in California so you can notify the California Franchise Tax Board and the IRS.
Understanding the Basics of Lawsuit Settlements
A settlement is a deal between parties to resolve a dispute without a trial. Each side would often reach these terms amicably, attempting to resolve their differences. Your lawyer should be able to evaluate the value of your claim.
Sacramento bike accident lawyer Glenn Guenard says a fair settlement should fully and fairly cover medical expenses and future care, loss of income, permanent disability, and pain and suffering.
Once a fair settlement is reached, both parties will experience a sense of relief and move forward.
Tax Treatment of Personal Injury Settlements
Generally speaking, tax is not applied to compensation for personal physical injuries. Settlements for personal injury, medical expenses, emotional distress and suffering are not taxable federal income.
On the other hand, settlements for punitive damages and money meant to be in lieu of lost wages to the degree the 1099 Form supplied by the defendant specifies such payments are taxable.
Keep detailed records for any settlement for, at the bare minimum, seven years. Should the IRS ever show interest in the specific matter, engage a tax expert to guarantee that you have the appropriate procedural knowledge to handle the possible tax situations and optimize post-settlement refunds.
Tax Implications for Employment Discrimination Settlements
Employment discrimination settlements have many tax implications, and tax treatment varies by type. As mentioned, settlements for lost wages are subject to income tax. Thus, as the plaintiff, you must report and pay taxes on this income.
If a settlement compensates for pain and suffering or emotional distress but not lost wages, the payout is not taxable. You might be required to report a portion of the damages as income if you deducted medical expenses related to emotional distress. Consult a tax consultant to understand your situation and comply with IRS settlement rules.
The Impact of Punitive Damages on Taxability
Punitive damages punish wrongdoing and deter it, while compensatory damages compensate for a loss. A punitive award is taxable income, so the IRS requires payment and a tax return.
In light of punitive damages, it is advisable to allocate a specific amount for tax payment to prevent potential tax complications that frequently occur when taxpayers opt for late payment.
Determining the general carryback of punitive damages, which will be deducted from your base wage, will help you plan and avoid tax surprises.
Reporting Your Settlement on Your Tax Return
When you get a settlement in a lawsuit, it is important to understand how to declare the income in your yearly revenue. Its suitability depends on the type of settlement.
Generally speaking, compensatory damages for physical injury or illness are not taxable. Conversely, although the tax return must include punitive damages and interest on the settlement, they are usually taxable.
Usually, you would classify any taxable sums as “Other Income” on your 1040 form if you received settlements for lost wages. It’s also advisable to hire a tax advisor to help you pay the right taxes and make a proper declaration of the settlement amount you received.
