You don't have to include non-taxable income on your tax return. Legal settlements are often taxable, but it depends on the type of settlement. The settlement type will be listed in your Final Settlement Agreement.
- Physical injury or sickness settlements (dog bites, mesothelioma, etc.) are nontaxable and don't need to be reported unless you deducted medical expenses related to the injury on a previous tax return, and you received a tax benefit from the deduction. In that case, report the medical expenses related to the incident as miscellaneous (other) income.
- Punitive damages (except certain wrongful death cases), and awards for employment discrimination and injury to reputation (libel, slander, or defamation) are taxable.
- Emotional distress and mental anguish settlements are taxable (unless they're related to physical injury or sickness), but only on the amount above and beyond the undeducted medical costs for treatment of the distress or anguish. You'll need to paper-file your return so you can attach a statement that shows the settlement amount minus the (undeducted) medical expenses related to treatment.
Settlements—Taxability
If the proceeds you receive for emotional distress or mental anguish (pain & suffering) do not originate from a personal physical injury or physical sickness, you must include them in your income.
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