If you thought that all the money you receive from the settlement of your lawsuit would be treated the same by federal tax law, you thought wrong. Some types of settlement amounts are considered income and subject to tax, while others are not. Proper planning of your settlement could potentially save you a lot of money. Failure to properly allocate and report settlement proceeds could result in the IRS knocking on your door.

The United States Internal Revenue Code (IRC) considers all money you receive, from whatever source, as taxable unless a specific exclusion applies. IRC § 104 covers exclusions from taxable income with respect to lawsuits, settlements, and awards.

Lawsuit claims, and their corresponding settlement awards, can generally be broken down into compensatory damages and punitive damages. The purpose of punitive damages is to penalize, or make an example of, the wrongdoer. The purpose of compensatory damages is to compensate a person for a loss. Compensatory damages can be further broken down into damages due to physical injuries or sicknesses, emotional distress, and economic harm such as lost wages.

Whether a settlement amount is classified as for punitive or compensatory damages, or relating to a physical injury or sickness versus a non-physical, economic loss, will determine whether that portion of the settlement award is subject to federal income tax. If the settlement award is to compensate you for lost wages, the money is probably subject to federal income tax, social security tax, and Medicare tax.

It is important to allocate every dollar you receive in a settlement award in the most tax-effective manner possible. Tax planning should be an important part of both your lawsuit and settlement strategy.

You may want to specify in the settlement agreement exactly what each part of the award is for—compensatory versus punitive damages, physical versus non-physical injury, and the like. In addition, from the beginning preparations for a lawsuit or other claim, you should collect adequate documentation to back up that allocation; for examples, medical proof of personal injury or sickness, documentation for out-of-pocket expenses, or calculations of lost wages and benefits. That way, if you are subject to an IRS tax audit, you will be able to support whatever allocation you made.

We’ll get into more detail on specific exclusions under IRC § 104, and what to be aware of with respect to the IRS, in Part II of this post.