Tax season is upon us and it seems like we’re being taxed on just about everything these days — including peer-to-peer payment platforms.
So, does that mean settlements are exempt? We did all of the digging to find out. Keep reading to see if Uncle Sam gets a chunk of a settlement.
Do you pay taxes on settlements?
Winning or settling a lawsuit is a big deal and a reason to celebrate. But before you start planning a trip to Tahiti, there are a few things you need to know, like if you have to pay taxes on settlements.
Lawsuit settlements and damages fall into two different groups: they’re either taxable or they aren't. The IRS states in Section 61 of the Internal Revenue Code (IRC) that all income is taxable unless it qualifies for an exemption under another section of the IRC, no matter the income source.
That means income from awards, lawsuits, and settlements are taxable unless the income includes damages received on account of physical injuries or sickness like a car accident or a slip or fall at work.
What types of settlements aren't taxable?
You can also avoid paying taxes on a settlement if damages are received for non-physical injuries such as emotional distress, defamation lawsuits, or humiliation caused by the accident. Emotional distress that isn't caused by a physical injury will be taxed.
Medical expenses incurred due to emotional distress or physical injury may not be taxable if no deduction was taken in the past.
How can I avoid paying taxes on a settlement?
As mentioned above, there isn't a way to avoid paying taxes on your settlement unless it’s physical injury or physical sickness. Even lost wages are considered taxable because it’s income that would have been taxed if you continued working. You’ll also be responsible for social security and Medicare taxes.
And to make matters worse, unless you fall into one of the above categories, you’ll be fully responsible for lawyer fees. And if you receive a lump sum payment, the large amount of money may even boost you into a higher tax bracket, which means you’ll pay even more in taxes!
Do I have to report settlement money to the IRS?
Whether you report it or not, the IRS will still know about your settlement and will still come after you to pay your taxes — therefore it’s in your best interest to report this money to the IRS.
And even if you made a mistake or forgot to report it, you'll still owe the IRS for the unpaid taxes. And if you don't pay them, the amount you owe will keep increasing due to fees and interest.
Don’t take a risk. If you won a settlement, congrats! Now go talk to a professional accountant to find out next steps.