Are Class Action Settlements Taxable?

Are class action settlements taxable? The rules regarding taxability for funds received via lawsuit settlements are established in Section 61 of the Internal Revenue Code. It states that all income may be subject to taxation irrespective of the source from which it has been derived unless another section of their code provides an exception, and such exceptions do exist.

Internal Revenue Code 104

Also known as IRC Section 104, it provides exclusions for some taxable income derived from awards, settlements, and lawsuits. However, the circumstances and facts for each settlement will need to be considered for determining why the funds were received. In other words, the intent and purpose of the settlement will determine whether or not it gets an exception.

For example, according to IRC Section 61, an exception can be made for damages that were rendered for specific discrimination claims as well as funds that were paid out due to physical injury. IRC Section 104 further states that damages received as the result of physical injuries are not considered gross income. This means that these funds are nontaxable.

Settlements And Awards

Settlements and awards may be broken down into two categories which can help to ascertain whether or not they are taxable. The first involves claims which are related to physical damages, while the second involves claims that involve nonphysical damages. These two categories can be further broken down into three more, which are:

• Punitive damages
• Actual damages derived from physical and non-physical injuries
• Damages from emotional distress which resulted from the physical injury

The IRS has consistently shown that compensatory damage, which includes lost wages that resulted from personalized physical injuries, may be excluded from one’s gross income and are therefore non-taxed. Damages received due to nonphysical injuries like emotional distress, humiliation, and defamation are generally considered part of gross income, but Federal employment taxation still can’t be applied to them.

Usually, punitive damages won’t be excluded from one’s gross income, but there is an exception. This exception is applied to damages that are awarded due to wrongful death, especially when state law has statutes that provide primarily for the punitive damages.

Employment-Based Litigation

Lawsuits that arise from employment disputes can come from things such as failing to honor one’s contract obligations or wrongful discharge. Damages that are rendered to cover for economic hardship, lost wages and business benefits should not be excluded from one’s gross income. The only exception is if physical injury caused the loss.

No Two Lawsuits Are Exactly The Same

There is no one rule that can be applied to every class action suit since each involves different circumstances. Some cases entail economic damages while others involve medical expenses or defective products. While the settlements from these cases are usually not taxable, as you can see there are numerous exceptions that must be taken into consideration. If your class action suit doesn’t involve discrimination, economic loss, investment devaluation, or physical harm, it may be taxable, so it is best to speak with an attorney or tax professional to be sure.