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  Ask the tax adviser By George Saenz, Bankrate.com    

Taxability of court-ordered money

Dear Tax Talk,
If someone gets a settlement from a pharmaceutical company for a lawsuit against a prescription drug they took, does it have to be claimed as income when doing taxes?
-- Robin

Dear Robin,
A settlement for personal physical injuries is never taxable. If the drug was proven to have adverse side effects that would cause physical harm, then the settlement would not be taxable income and would not be reported on your tax return.

A settlement that stems from mental suffering, however, such as age or sex-based discrimination, would be taxable.

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In an interesting turn, the law has changed with respect to the deduction of contingent attorney's fees in damage awards. Usually an attorney will accept a damages case on a contingent-fee basis. The attorney charges up to 40 percent of the awarded damages.

The Internal Revenue Service has been contending in the courts for a while that the litigant must claim the full amount of the damage award as income, if otherwise taxable, and claim a miscellaneous itemized deduction for the 40-percent attorney's fee. Since miscellaneous itemized deductions are not tax deductible for alternative minimum tax, a claimant ended up with little of the award after paying the attorney and the IRS.

The IRS was successful when the Supreme Court decided in January that its position was a correct interpretation of the law. However, the decision was rendered practically moot by the American Jobs Creation Act of 2004. The act changed the rules so that a claimant will only pay tax on the amount awarded net of attorney fees. This new law applies to a broad array of legal claims. Unfortunately however, the act's provision is only effective for awards and settlements occurring after its enactment on Oct. 22, 2004. For those cases settled prior to that date, it appears that the IRS's position will be the governing rule.

-- Posted: Feb. 15, 2005

  Read more Tax Adviser columns

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See Also
Legal settlements and your tax bill
Taxable vs. nontaxable income
Taxes on workers' comp money
Tax glossary
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