Ask the tax adviser
Taxability of legal-settlement proceeds
Dear Tax Talk:
Please explain if and/or when proceeds from a
legal settlement are taxable. Specifically, how are actual damages,
punitive damages, and accrued interest on the award treated with
respect to taxes? Are they all treated as ordinary income?
Generally, the only legal settlements that are not taxable are those
that relate to recovery of damages for physical bodily injury. Examples
of settlements that are tax-free for personal injury include a car
accident, a slip and fall, wrongful death, etc.
Settlements for age or race discrimination and sexual
harassment actions are taxable.
Punitive damages in a physical injury claim are not
taxable. In most other claims, punitive damages are taxable.
Prejudgment interest is always taxable, as it is not
received on account of physical injury but rather on account of
the time value of money.
All settlements are treated as ordinary income, not
capital gains, unless the settlement relates to the sale of a capital
asset, such as land or a building.
-- Posted: Oct. 25, 2001