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Dear Tax Talk,

I am due to receive a settlement where the proceeds are for “pain and suffering.” My attorney could not answer my question about whether any of it was taxable, other than the “lost wages” portion. Do I owe the feds anything for pain and suffering? It seems to me that this would not be counted as “income,” but that is just my thinking. What does the law say?

— Alan

Dear Alan,

The short answer is: It depends on your facts and circumstances. If your lawsuit was for “personal physical injuries or physical sickness,” then generally the settlement proceeds are not included in your income. An exception applies when some of the proceeds are paid to reimburse you for medical expenses that you deducted on your tax return. If the proceeds were not for personal injuries, then some of it may be taxable to you.

Settlement proceeds include amounts received by settling a case before going to trial or by going to court and having a verdict issued for damages. They can include multiple elements such as allocations for back pay, emotional distress and attorney fees.

However, if your settlement is related to an “employment-related claim” such as discrimination or involuntary termination, then the proceeds for lost wages are includible in your income subject to not only income tax but also to the Social Security wage base and Medicare taxes. In these cases, if you receive amounts for emotional distress or mental anguish, then you must report them on your tax return after deducting medical expenses for which no tax benefit was received. IRS Publication 525 covers this in the section titled “Recoveries.”

Thanks for the great question and all the best to you.

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