Settlement from Lawsuit is it Taxable

[Julia813]

In 2021 I received a settlement for a lawsuit related to denied healthcare for procedures that were illegally denied by the insurance plan. I was one of eight plaintiffs, and we each received a part of the settlement based on our out of pocket costs to pay for care that should have been covered, plus we each received emotional distress damages as well. The settlement was paid to our law firm who then in turn paid each plaintiff. I was issued a 1099-MISC for the full amount of what I was sent to me by the law firm as part of the settlement. 

I am not clear how much if any of the settlement is taxable. I received approximately $36,000 from the settlement, and of that $13,000 was reimbursement for my out of pocket medical expenses, and $23,000 was listed as emotional distress damages. What of this is taxable (if any) and how do I report that using TurboTax. I assume since I have a 1099-MISC I need to add it to my filing, but how do I offset the amount that should not be taxed. 

Thank you,

Julia

[GeorgeM777]

Some of your legal settlement may be taxable and some of it may not.   Your question is fairly complex in that it relates to your lawsuit and probably requires an analysis of all of the facts and circumstances related to that lawsuit.  Accordingly, much of what you ask about is beyond the scope of the type of advice we can provide.  However, we can provide some general background information for you so that you can raise these issues with your tax advisor. 

Generally, awards and settlements can be divided into two distinct groups to determine whether the payments are taxable or non-taxable. The first group includes claims relating to physical injuries, and the second group is for claims relating to non-physical injuries. Within these two groups, the claims usually fall into three categories:

1. Actual damages resulting from physical or non-physical injury;
    
2. Emotional distress damages arising from the actual physical or non-physical injury; and
    
3. Punitive damages

Damages received for non-physical injury such as emotional distress, defamation and humiliation, although generally includable in gross income, are not subject to Federal employment taxes.  Federal employment taxes are social security and medicare taxes.  

Emotional distress recovery must be on account of (attributed to) personal physical injuries or sickness in order for it not to be subject to tax.   However, if the emotional distress recovery is for reimbursement of actual medical expenses related to emotional distress that was not previously deducted, then such amount is not taxable.   You mentioned that some of the money you received was for reimbursement of medical expenses so that amount may not be taxable. 

There is a section of TurboTax concerning legal settlements.  In the Federal section, under Wages & Income, scroll down to the bottom of the page where you will find Miscellaneous Income.  At the bottom of that section, select Other Income and answer the questions in the pages that follow.  However, before you take this step, you might want to discuss the matter with your tax advisor to get a better understanding of what amounts of your legal settlement are taxable.

@Julia813

[Julia813]

George,

Thank you for your reply. I do realize that this is a fairly complex situation that my accountant struggled with so that is why I thought about reaching out. My accountant and I reviewed publication 4345 which I think what we discussed seems similar to your answer. He feels fairly confident that the part that is reimbursed medical expenses are not taxable, especially since I never deducted them in previous years, but the emotional distress damages are a bit more complicated. He said he would do some more research, and I am trying to as well.

Thank you for the recommendation of where to look in TurboTax, and thank you for your help!

[DianeW777]

We also have an article that may be helpful for you when it comes to taxable settlements. It's posted here for your review.

• Are legal settlements taxable?
• Where do I enter an award from a taxable legal settlement?

It sounds like you have reviewed IRS Publication 4345 thoroughly and our awesome Tax Expert @GeorgeM777 has laid out clearly the contents of emotional distress or mental anguish. (Here is the paragraph about that topic.)

• The proceeds you receive for emotional distress or mental anguish attributable to a personal physical injury or physical sickness are treated the same as proceeds received for Personal physical injuries or physical sickness above.
  • –BUT– ‧
• If the proceeds you receive for emotional distress or mental anguish do not originate from a personal physical injury or physical sickness, you must include them in your income. However, the amount you must include is reduced by:
  • (1) amounts paid for medical expenses attributable to emotional distress or mental anguish not previously deducted and (2) previously deducted medical expenses for such distress and anguish that did not provide a tax benefit.
• Attach to your return a statement showing the entire settlement amount less related medical costs not previously deducted and medical costs deducted for which there was no tax benefit. The net taxable amount should be reported as “Other Income” on line 8z of Form 1040, Schedule 1.