Court settlements or damage awards that are received for physical injuries or physical illness are tax-free.
If you’re audited, IRS auditors will look at the court paperwork to see what was filed as the original grounds for the lawsuit. Then, they will look at the settlement agreement to see how the final agreement characterizes the amounts that had been received.
Damages received for emotional distress are generally taxable with two important exceptions. Amounts that are paid for mental anguish that arises from physical injuries are tax-free. Additionally, if there is a reimbursement for medical treatment of emotional trauma it is also tax free.
In the recent case of Blum, an injured woman had an unusual set of circumstances that created a taxable situation. Her injury came about when she was in the hospital and sat on a broken wheelchair. She was injured and sued the hospital.
She then sued the lawyers who had represented her for malpractice. She eventually settled with them.
The proceeds she received from the law firm due to malpractice which caused her to lose her action against the hospital WERE taxable. If she had instead won the first case, the proceeds would NOT have been taxable.
If you’re involved in a court action, talk to your experienced CPA or tax attorney before you get the final settlement. Just a little change in wording could make a big difference in taxes.
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