How many taxes will be taken out of my lawsuit settlement?

Question

I just won a settlement for 35,000 compensatory damages and 10,000 punitive damages. How much tax will be taken out of the compensatory? I know that the 10,000 for punitive will not be taxed.

Answer 1

That depends upon what the settlement is for.

Settlements for physical injury or illness are not taxed. If any part of the settlement is earmarked for lost wages, interest, or punitive damages that portion IS fully taxable as ordinary income.

Additionally, settlements that simply make you whole again are not taxable. For example if an uninsured drunk driver slammed into your house and the settlement was to repair the damage to your home it would not be taxable to the extent that it was used for the actual repairs. Any amount above and beyond the actual cost of the repairs would be taxable as ordinary income.

Not sure where you heard that punitive damages are not taxable. Punitive damages are ALWAYS taxable. The only exception to that is if your state's laws prohibit the award of punitive damages. In that case they would be treated as compensatory damages and would be taxable or not depending upon the reason for the settlement.

So, without knowing what the settlement was for it's not possible to give an absolute answer to your question.

Answer 2

Compensatory damages not taxable.

The United States Court of Appeals for the District of Columbia has held that compensatory damages received for emotional upset and harm to reputation, but not connected to any physical injury, are not taxable as income. See Murphy v. I.R.S. (D.C. Cir. Aug. 22, 2006). The court's decision is the first federal appeals court decision to rule on the taxability of compensatory damages not connected to physical injuries.

Punitive damages are taxable.

In 1989, Congress amended Internal Revenue Code section 104(a)(2) by making punitive damages taxable in cases that did not involve physical injury or physical sickness; however, it was not clear whether those punitive damages were excludable. The Small Business Job Protection Act of 1996 generally made all punitive damages taxable but included one exception for punitive damages awarded in a civil action for a wrongful death. This new law became effective for amounts received after August 20, 1996, the date the law was enacted.

Answer 3

You've got it backwards. The punitive WILL be taxed. Under most circumstances, the compensatory won't be.

Answer 4

Interesting question!

Answer 5

None.