How to Report Legal Settlement Taxes
Some, but not all, of the funds you receive from a legal settlement must be reported as taxable income. The Internal Revenue Service (IRS) determines whether the income is taxable by evaluating what type of item the settlement income replaces. For example, if you receive a settlement for back wages, which would have been taxable if they had been paid when they were earned, the settlement is taxable. Most settlement funds are taxable as ordinary income, but some may be taxed as capital gains.
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Things You'll Need
- Court order (or other document) with details of the settlement
- IRS Form 1040
Instructions
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Find the specific amount you were paid for each item listed in the settlement. This information is often in a section called "Terms." Examine the document carefully to find the explanation for every amount you were paid.
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Report items that qualify as ordinary income on the line of the tax form for "Other Income." The following items are considered ordinary income: interest on the settlement award, payment of lost wages or profits, punitive damages of any kind, payments that compensate for your right to a pension (but only if you did not contribute to the pension fund), damages for business-related harms (patent infringement, breach of contract, interference with operation of your business), back pay, and damages for civil rights claims and attorney fees and costs.
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Report items that qualify as capital gains on the line of the tax form for "Capital Gains." Capital gains may occur when you are awarded an asset rather than, or in addition to, a cash payment. In a divorce settlement, for example, you may be awarded real estate, mutual funds, investment funds or similar items.
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Refrain from reporting any amount paid as damages to compensate for a physical injury or physical illness. These payments are not taxable.
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Determine whether payments for emotional distress are taxable by looking at the cause of the emotional distress. Do not report payments for emotional distress that resulted from a physical injury or physical illness. These payments are not taxable. Report payments for emotional distress that resulted from any other type of injury as ordinary income. You may, however, deduct any amount paid to cover medical care for the emotional distress before reporting the income.
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Tips & Warnings
Although the part of the settlement paid to cover attorney fees and costs must be reported as taxable income, the expense may qualify as a deduction in some circumstances.
Settlement agreements may be complex. Consult a tax professional to help you classify income that does not easily fit one of the categories identified by the IRS.
Tax laws change frequently. Check for changes in the law before you file taxes.
References
Resources
- Photo Credit tax forms image by Chad McDermott from Fotolia.com
