Whenever an American citizen receives any kind of substantial windfall, there is an expectation for the U.S. government to come looking for its share through taxation laws. While some things like lottery winnings are absolutely subject to taxation, other types of monetary awards are not. In the U.S., only certain types of case awards from legal matters qualify for taxation.
As a general rule, any proceeds from a lawsuit for a physical illness or injury do not qualify for taxation. For example, if you won a personal injury lawsuit after a drunk driver hit your vehicle and broke your legs, the resulting settlement or jury award would be tax-exempt. You would not have to report the proceeds as part of your gross taxable income.
Understanding Taxes and Your Personal Injury Settlement in AZ
Personal injury cases can arise from various situations, and not all of them may include physical injuries. For example, a lawsuit citing damages for emotional distress without any physical injury may succeed, but the plaintiff would not enjoy the same tax benefits as he or she would if the case award resulted from a physical injury.
However, if the plaintiff can prove even the slightest physical injury in the issue, such as emotional abuse so severe the plaintiff went into shock or an eating disorder as a response to emotional trauma the tax liability would change.
Some personal injury claims involve multiple charges. For example, a plaintiff may file a lawsuit against a defendant for a personal injury and a breach of contract, and the plaintiff would need to outline the damages associated with each claim. While the damages from the personal injury would not qualify for taxation, those resulting from the breach of contract would. This is why it is extremely important for plaintiffs to carefully define the scope of their damages and determine which damages apply to which charges.
Non-Exempt Legal Proceeds
While the IRS cannot touch proceeds from a lawsuit for a physical illness or injury, punitive damages are always taxable. If a jury awards a plaintiff punitive damages, the plaintiff must pay the appropriate taxes on those damages. It is a wise choice for a plaintiff to ask the judge to carefully outline which compensation applies to the plaintiff’s physical injuries and other damages and how much reflects punitive damages so the plaintiff has a reliable record of his or her tax obligations from the lawsuit.
Judgment interest would also qualify for taxation. For example, the defendant in a personal injury lawsuit may not actually start paying the plaintiff’s compensation for quite some time after the conclusion of the lawsuit. Suppose a plaintiff files a lawsuit on January 1, 2018, secures a judgment in his or her favor on January 1, 2019, but the defendant appeals the decision and ultimately loses on January 1, 2020. The plaintiff would receive interest on the judgment starting on the date of filing the lawsuit and lasting until the plaintiff has received full payment. In this example, the case would accrue two years of taxable interest.
Penalties for Missing Tax Obligations in Arizona
It is essential to ensure you pay your taxes as necessary on all proceeds from a lawsuit. If you are unclear about your tax obligations, consult with your attorney and make sure you list your damages accurately in such a way that you can clearly define what is and what is not taxable in your case. Failure to pay taxes as required could lead to heavy fines or even jail time for tax fraud.
It is also important to review how taxable earnings from a lawsuit may influence your overall tax liability. For example, if you receive a large sum of punitive damages on your lawsuit, you will not only owe taxes on this amount, but the amount you receive still qualifies as taxable income and may place you in a higher tax bracket for that year. Attorney John Phebus and certified tax professionals are the best resources for determining tax liability after a lawsuit.