Parties to a lawsuit must consider the tax ramifications of a jury verdict or an out-of-court settlement. Defendants can consider tax consequences in order to pay the lowest possible amount to resolve a claim. Plaintiffs and their attorneys must know which claims in a lawsuit are subject to federal tax and if certain claims can be dismissed to provide a tax benefit upon settlement.
Federal law excludes from gross income certain damage awards in the United States Code at 26 U.S.C. 104. Any money received by an individual as compensation for personal physical injuries or physical sickness is not subject to federal income tax. This exclusion applies to awards obtained in a jury verdict or in an out-of-court settlement. Plaintiffs can enjoy this exclusion regardless of whether they receive a series of payments or a lump-sum award.
Only certain claims escape federal income tax. Jeff Schnepper of MSN Money points out the "personal physical injuries or physical sickness" requirement of the statute. Serious physical injuries like broken bones and herniated discs would qualify under this statute. Less serious injuries like muscle strains, cuts and bruises would also qualify. The IRS training manual for lawsuits and settlements provides that individuals suffering only emotional, as opposed to physical, injuries can only exclude from income their verified out-of-pocket expenses associated with the emotional injury.
Claims not involving physical injury or out-of-pocket costs for emotional injury will be subject to federal income tax. Schnepper writes that lawsuits for breach of contract or sexual discrimination would not qualify under the statute. Other excluded claims would include libel, slander, wrongful eviction and civil theft. Any awards received as punitive damages, even those stemming from a personal injury claim, are treated as taxable income.
Schnepper provides an example of a plaintiff with a $1,000,000 sexual discrimination suit and explains how that plaintiff can save money on taxes by designing a settlement that applies most of the proceeds to non-taxable claims like bruising, while applying a smaller percentage of the settlement to taxable claims like harassment. However, the IRS warns its employees to carefully consider these "allocation" issues, predicting that parties will allocate the majority of settlement proceeds to non-taxable claims.