Yesterday, the U.S. Tax Court issued an opinion in the case of Ruffin v. Commissioner, that provides helpful information as to how to determine if litigation settlement proceeds are taxable or not.
In short, you must look at the nature of the claim that is the basis for the settlement. If the nature of the claim is such that the settlement proceeds represent damages that stand in place of taxable income, then the settlement proceeds are taxable.
For example, in Ruffin, the taxpayer was part of a class action against the City of Chicago, alleging politically motivated discriminatory hiring practices. The taxpayer in essence claimed that she did not get a job because of political discrimination.
The taxpayer did not think that she should have to include the settlement proceeds in her taxable income. The IRS disagreed, and the Tax Court agreed with the IRS.
Since the settlement proceeds essentially replaced wages that the taxpayer would have received if she had been hired, the nature of the damages she received were properly treated as taxable income.
In discussing the nature of the claim and the nature of the damages, the Tax Court also noted that generally settlement proceeds that are based on physical injury or sickness are not included in taxable income. The big exception to this general rule, though, is that even physical symptoms arising out of emotional distress do not give rise to nontaxability. For example, if a taxpayer has emotional distress and suffers physical symptoms as a result, such as insomnia, headaches, or stomach disorders, those physical injuries still do not mean that the settlement proceeds received are non-taxable.
On the contrary, settlement proceeds intended to compensate a taxpayer for physical symptoms arising from emotional distress are taxable.
Physical injuries and sickness that do not arise from emotional distress, however, such as physical injuries sustained in car wrecks, are nontaxable under Code Section 104.
The bottom line is this: if you’re involved in litigation, always discuss the taxability or nontaxability of settlement proceeds or court awards with your lawyer.