If you receive proceeds from settlement of a lawsuit, there may be tax implications. Whether you must include the settlement proceeds in your income depends on the type of settlement.
Lost Wages: If you receive a settlement in an employment-related lawsuit, the portion of the proceeds that is for lost wages is taxable income. In addition, the proceeds are subject to Social Security and Medicare tax.
Lost Profits: A settlement for lost profits from your trade or business is taxable. Lost profits are also subject to Social Security and Medicare tax (also known as “self-employment tax”).
Emotional Injuries: The proceeds you receive for emotional distress or mental anguish are taxable and must be included in your income. Physical symptoms of emotional injuries (such as headaches) are also taxable.
Physical Injuries and Physical Sickness: Settlement proceeds for physical injuries and physical sickness are non-taxable and are not included in your income (as long as you did not take an itemized deduction for medical expenses related to the injury or sickness in a prior year). The settlement agreement must clearly designate the proceeds as compensation for physical injuries / physical sickness. Otherwise, it may appear as if the proceeds are for taxable emotional injuries or lost wages.
Damaged or Destroyed Property: If a settlement for the loss in value of property exceeds the property’s adjusted basis, the excess amount is taxable income. If the settlement is less than the adjusted basis of the property, it is not taxable, but you must reduce the basis in the property by the amount of the settlement.