When you receive proceeds from a legal settlement, you may not need to pay certain taxes, depending upon the circumstances. Here are some points to consider following your settlement:
Personal Physical Injuries or Physical Sickness
If you received a settlement for personal physical injuries or physical illness, and you did not deduct medical expenses on your return, then you do not pay taxes on the amount received. However, you must include in your income the portion of the settlement for medical expenses that you deducted in any prior years, if the deduction provided a tax benefit.
Emotional or Mental Distress
If you underwent emotional distress or mental anguish from a personal physical injury or physical illness, the proceeds are not taxable. If the emotional distress is not caused by personal physical injury, then you need to treat the proceeds as income and pay taxes on them. However, the proceeds you include as income can be reduced by:
- The medical expenses you made to treat the emotional distress or mental anguish
- The medical expenses related to the emotional distress or anguish that you did not previously deduct to realize a tax benefit.
If you received proceeds in a settlement related to lost wages (i.e., back pay, severance pay), then the proceeds will be treated as income and taxed.
The proceeds from lost wages are treated as regular wages. The proceeds are subject to employment tax withholding by the payer. These proceeds need to be reported as ‘wages, tips, salaries, etc.’ on line 7 of Form 1040.
Lost Profits from Business
If you received proceeds from a settlement for lost profits from your business/trade, then the part of the proceeds assigned to sustaining your business are considered taxable income, subject to self-employment tax. You need to report this under ‘business income’ on line 12 of Form 1040. When calculating your self-employment tax, you need to include it on line 2 of Schedule SE, Form 1040.
Property settlements for loss in value of a property are not taxable and need not be reported on your return, if they are less than the adjusted basis of your property. However, if they are more than the adjusted basis of your property, the excess amount is treated as income and is subject to tax.