What is a Lawsuit Settlement Tax?

A settlement tax refers to a levy imposed by the government upon the money an individual or business entity receives to settle a lawsuit. Settling a lawsuit occurs when parties involved in litigation resolve their dispute before a court enters a judgment on the case. Laws vary as to what types of settlement proceeds are subject to a settlement tax. The facts of each situation control whether a tax may apply. 

In the U.S., for example, income is taxable unless the law provides a specific exemption. An exemption means that the law excludes it from taxation. Money received in a settlement is subject to a settlement tax unless a specific exemption exists. As a result, it is necessary to determine how the government classifies settlement proceeds. 

Money received in a settlement for physical injuries or for a sickness are not subject to a settlement tax in the U.S.. Generally, all other settlement proceeds are subject to a tax. This includes punitive damages, compensation for lost wages, interest on the settlement itself, lost profits, money received for emotional distress, damages for breach of contract, and any other damages not specifically exempted. Certain types of back pay are not subject to the tax, however. A person should consult with a qualified lawyer or tax professional in his or her jurisdiction to determine whether settlement proceeds are subject to a settlement tax because each situation is fact dependent and laws constantly change.

A settlement tax may also apply to settlement proceeds used to pay an attorney. The law, however, permits an individual to claim a deduction for the amounts paid for legal services. Expenses or costs to pursue a lawsuit may also be deductible. For instance, fees paid to a private investigator to gather information for the lawsuit may be deductible. The issue of concern for the government is why a person is receiving settlement proceeds. It is not how a person expends such proceeds.

When parties settle a lawsuit, they may attempt to classify the proceeds in a manner to minimize or avoid a settlement tax. For example, since a settlement tax applies to punitive damages, the parties may classify these damages in another way to avoid the tax. The government, however, is not obligated to honor the terms of the settlement agreement. Indeed, the government may look to the circumstances of the situation and reallocate the proceeds, which means it can tax the money despite the terms of a written settlement. This makes it vital to consult a tax professional to avoid penalties.