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Class Action Lawsuit Settlement: Good News or Bad For Your Taxes?

Written by Eva Rosenberg on June 2, 2010 in Tax  |   10 comments

I recently received a question from Susan, who wanted to know if a settlement from a class action suit is taxable. Great question, but it’s also very broad and open-ended. A number of examples came to mind. First, let’s talk about the woman who won…

Taxes affected by class action lawsuits
I recently received a question from Susan, who wanted to know if a settlement from a class action suit is taxable.

Great question, but it’s also very broad and open-ended. A number of examples came to mind.

First, let’s talk about the woman who won a substantial settlement, in the high six figures, from one of the aerospace companies operating out of Burbank, California.

You’d think a settlement like that would be wonderful, right? Unfortunately, this company’s plant had been so toxic to the entire area that the woman and many others had developed a variety of cancers. While the money was nice to have, the recurring cancers were not. Her lawsuit settlement was not taxable.

Then there is the pittance that school bus drivers at the Los Angeles Unified School District (LAUSD) received recently. They sued LAUSD because the district was not paying them per the contract that had been in force for the last decade and a half. LAUSD had been shorting them about 25 percent of their compensation, sick pay, vacation pay, and retirement benefits.

Although the district admitted to the judge that the drivers’ claim was correct, LAUSD still has not corrected the practice. Its attitude? Sue me! Each driver got about $2,000. That lawsuit settlement was treated as wages and subject to payroll taxes.

And let’s not forget the Bernie Madoff situation. Some victims were able to get some of their money back. Some were forced to return money to the Madoff bankruptcy estate first, even though they had substantial net losses. Not only was their lawsuit settlement not taxable, but these Madoff victims may have ended up with substantial net operating losses to apply against prior years-or future years.

(If you are a Madoff victim, here’s guidance from the IRS, and the Taxpayer Advocate Service.)

So let’s get back to Susan’s question. Whether the lawsuit settlement is taxable depends on the nature of the class action suit.

When the lawsuit is related to physical harm you suffered, such as cancer as a result of toxic wastes being deposited in an area (as in Burbank), the judgment is not taxable.

When a lawsuit is related to anything that did not cause physical harm-discrimination of any kind, loss of income, or devaluation of an investment-the lawsuit settlement proceeds are taxable.

Whether the income will be considered ordinary (top tax rates), capital (special investment rates, potentially), lost wages (subject to payroll taxes), or self-employment (subject to self-employment taxes of 15.3 percent plus the top marginal tax rate) all depends on the nature of the lawsuit.

To go deeper into this issue, check out the IRS’s audit guide for lawsuit settlements. IRS auditors use this to investigate the taxability of a settlement. You can’t get better information than this!

IRS Publication 525 discusses taxable and nontaxable income.

With significant lawsuit settlements, it can be worth your time to sit down with a good tax professional to review your settlement before you receive it. In some cases, in a small class action lawsuit, you may have some control over the final structure of the settlement and may be able to reduce the tax impact.

Eva Rosenberg, EA is the publisher of TaxMama.com, where your tax questions are answered. Eva is the author of several books and ebooks, including Small Business Taxes Made Easy. Eva teaches a tax pro course at IRSExams.com.


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10 comments

  1. Ilyce Glink says:

    Eva:

    This is a great explanation of the difference between taxable and nontaxable settlements. Thanks.

  2. personal injury lawyer says:

    i really like this article..i just want to appreciate you for this work..and i would like to read more article on this…

    Debt Management Plan

  3. warpcoredc says:

    Thanks for the article, but I feel I am a member of a class in a gray area. Our class settled with the DC Government for a civil rights violation and inhumane treatment (hog tied, water deprivation, inhumane conditions). http://www.beckersettlement.com/ Would this settlement fall under the emotional and/or physical harm tax-exempt clause? Our award is only in the thousands and a tax attorney would take a chuck of it to ask directly :(

  4. Administrator says:

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  5. cathy says:

    What form/schedule or line number do you report this on, to the irs?

  6. Jen says:

    My 19 year old son and myself have been involved in a cancer, death, sickness and birth defect class action lawsuit which we will be awarded amounts in the low six figures. My question is that if the amounts awarded are not tax deductible then do these amounts have to be disclosed as income or asset? ie FASFA application.

    • EFX Moderator, KB says:

      Jen, I would advise you to talk to an accountant about your issue. He or she should be able to give you further assistance. Best of luck.

  7. Alice says:

    My husband got a death settlement from a brother that was hit by a car.

    My husband also got a settlement from Country Wide mortgage.

    Does he half to claim taxes on either of these

  8. TaxMama® (@TaxMama) says:

    Dear Alice,

    So sorry for the loss of your brother-in-law. What a terrible way to go.

    The death settlement is probably not taxable at all. But someone needs to read the insurance documents that define the settlement. If there was a loss of earnings element, that part would be taxable.

    As to the settlement from CountryWide?
    I have no idea. What was the settlement for?
    If it was for something like too much interest being charged, that would be taxable, since you deducted the excess interest when you paid it.

    If it was for some kind of punitive damages, those are always income because there is no physical injury involved.

    It could have been for something else…in which case, while it might not be taxable, it would reduce the cost basis for the property.

    I hope this helps?

    Hugs
    Eva


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