Are Class Action Lawsuit Settlements Taxable?

It’s tax season in the United States, and the April 15^th deadline is quickly approaching. You’re responsible for accurately recording and submitting your income tax assessments to the Internal Revenue Service (IRS) – and all income, whether it be salary, hourly wages, freelance earnings, inheritance money, investments, or other sources, may be taxable.

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If you’re the victim of discrimination and, say, lose your job, and this leads to emotional distress, any settlement money you receive will remain taxable.

Under that “other sources” category, you may wonder about lawsuit settlement money. While the amount of money you can receive from a settlement will vary between cases, one question seems to come up time and time again: Do you pay taxes on settlement money?

It will come as no great surprise that the answer is almost universally yes. Settlement money counts as income, and the amount, including any interest on the award, must be declared accordingly.

Now, as with all matters related to taxes, exceptions exist. The IRS never seems to make things simple, after all, but ClassAction.org is here to help.

Which Settlements Are Tax-Free?

The IRS recognizes settlement money from cases involving “observable bodily harm” as tax-exempt under part 26 U.S.C. § 104(a) of the tax code. The criteria for this exemption are pretty specific. An individual needs to have received the award as compensation for physical injury or sickness and/or emotional distress caused by physical injury or sickness (punitive damages remain taxable even in these circumstances.) The physical / emotional injury also needs to be the result of a wrongful act. So, if you suffered a back injury at work because of faulty equipment, and you sued the product’s maker for negligent design, any settlement money you received may be tax-free. Equally, if the injury leads directly to emotional distress – anxiety, for example – the money may be tax-free because of this direct link.

Which Settlements Are Taxable?

If you’re the victim of discrimination and, say, lose your job, and this leads to emotional distress, any settlement money you receive will remain taxable. Why? While emotional distress that’s linked to a physical injury can qualify settlement money as being tax-exempt, emotional distress in and of itself does not. The link to a physical injury is crucial, and the IRS is likely to be vigilant about these things. Take, as an example, the class action lawsuit filed by motorists caught up in New Jersey’s “Bridgegate” scandal. Drivers were stuck for hours in traffic jams, and a class action lawsuit is seeking compensation for a number of damages, including emotional distress. Should the plaintiffs win their case and receive compensation, it will be taxable at the normal income rate. No physical harm, no tax-free settlement money.

Attorney's fees are also taxable, and in situations where these were expected to be paid out of a lump sum payment, it is your responsibility to keep records of these payments to ensure you don’t end up paying taxes on money you no longer have.

Making sense so far? When in doubt, always seek advice from an accountant. Also, be sure to check out the IRS’ website (www.irs.gov).

Now, class action lawsuits are generally designed to deal with situations where the injury is material (i.e., a defective product or consumer fraud), rather than physical (personal injury or sickness). So, class action settlement money will, in general, be taxable. The same goes for any awards resulting from employment lawsuits, or any lawsuit that does not involve physical harm.

Are you owed unclaimed settlement money? Check out our class action rebates page full of open class action settlements.