Do I Have to File Taxes on Case Settlements?
Taxpayers strive to make the most out of their deductions. If it is legal and possible to retain forms of income, such as money, a taxpayer generally wants to take full advantage of those options. In certain instances, settlement money can be tax-free, but it may depend on how it is used and structured.
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IRS Definition of Income
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Taxpayers must pay taxes on gross income. The Internal Revenue Service uses a broad definition of income. Under the Internal Revenue Code -- the laws regarding taxes at the federal level -- gross income includes "all income from whatever source derived." The IRC lists several examples of income including fees, fringe benefits and wages. In some instances, settlement money is taxable income.
Case Settlement Money
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At first blush, case settlement money appears to meet the broad definition of gross income: the money is received by the taxpayer for her use; it represents a gain of wealth and might be loosely described as compensation. In general, the lump sum of a settlement is tax free if it meets two requirements, according to MSN.com. For a settlement to be tax-free, it must be received as a result of a physical injury as opposed to an emotional injury, and it must be the result of a wrongful act, according to MSN.com).
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Interest Earned on Settlement Money
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In some cases, a court may award interest to the lump sum. According to FreeAdvice.com, interest earned on the lump sum is taxable and must be reported to the relevant tax authorities. In certain cases, the settlement amount may represent both physical -- tax-free injuries -- and emotional -- tax-liable -- damages. Taxpayers may be able to save money on taxes by structuring a settlement.
Structuring a Settlement
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A structured settlement pays money to the taxpayer over time. While the taxpayer does not immediately have access and control over the entire settlement amount, the way the amount is structured can have significant tax implications. Receiving a lump sum settlement that contains both taxable and tax free amounts can place the taxpayer in a higher tax bracket thereby incurring a higher tax liability, according to MSN.com. Receiving smaller disbursements over time through a structured settlement may save the tax payer money. For instance, if the taxpayer received a lump sum settlement containing $500,000 of taxable income, she would have to pay the taxes on the $500,000 up front and the $500,000 would place her in a higher tax bracket. If instead she received structured payments containing lesser sums of taxable income that did not increase her tax bracket, she would save money over time.
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