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The nature of the settlement determines the taxability of the money received. See below for a breakdown.....
Personal Physical Injuries or Physical Sickness
If you receive a settlement for personal physical injuries or physical sickness and did NOT take an itemized deduction for medical expenses related to the injury or sickness in prior years, the full amount is non-taxable. The settlement proceeds would NOT be included as income.
BUT, you must include in income any portion of the settlement that is for medical expenses you deducted in any prior year(s) to the extent the deduction(s) provided a tax benefit. If part of the proceeds is for medical expenses you paid in more than one year, you must allocate on a pro rata basis the part of the proceeds for medical expenses to each of the years you paid medical expenses.
Emotional Distress or Mental Anguish
Any settlement proceeds you receive for emotional distress or mental anguish originating from a personal physical injury or physical sickness are treated the same as proceeds received for the section above.
BUT, if the proceeds you receive for emotional distress or mental anguish do NOT originate from a personal physical injury or physical sickness, you must include them in your income. However, the amount you must include is reduced by: (1) amounts paid for medical expenses attributable to emotional distress or mental anguish not previously deducted and (2) previously deducted medical expenses for such distress and anguish that did not provide a tax benefit.
Lost Wages or Lost Profits
If you receive a settlement in an employment-related lawsuit; for example, for unlawful discrimination or involuntary termination, the portion of the proceeds that is for lost wages (i.e., severance pay, back pay, front pay) is taxable wages and subject to the social security wage base and social security and Medicare tax rates in effect in the year paid. These proceeds are subject to employment tax withholding by the payor and are reported on the tax return.
If you receive a settlement for lost profits from your trade or business, the portion of the proceeds attributable to the carrying on of your trade or business is net earnings subject to self-employment tax. These proceeds are taxable and should be included in your tax return’s “Business income”.
Loss-in-Value of Property
Property settlements for loss-in-value of property that are less than the adjusted basis of your property are not taxable and generally do not need to be reported on your tax return. However, you must reduce your basis in the property by the amount of the settlement.
If the property settlement exceeds your adjusted basis in the property, the excess is income.
Interest on any settlement is generally taxable as “Interest Income” and should be reported on the tax return.
Punitive damages are taxable and should be reported as “Other Income” on the tax return, even if the punitive damages were received in a settlement for personal physical injuries or physical sickness.