Do I Have to Pay Taxes on Money Received From a Class Action Lawsuit?
Class action lawsuits allow parties to resolve claims affecting large numbers of people. Because the number of injured people prevents each from actively taking part in the lawsuit, a limited number of plaintiffs are named as the class representatives. Typically, the resolution of a class action lawsuit results in small settlement checks being sent to each class member, unless a member has chosen to opt out and pursue the claim on her own. Members accepting settlement checks must consider the tax consequences.
Exclusion to Federal Gross Income
The Internal Revenue Code determines what income is subject to income tax. Typically, the IRS treats the receipt of anything of value as income. However, Title 26, Section 104, of the United States Code allows people receiving compensation for personal physical injury or physical sickness to exclude those amounts from their gross income. Any income obtained from a class action lawsuit settlement will be subject to tax unless the settlement is exempted from tax under this statute.
Distributions from Class Action Lawsuits
People eligible to share in a class action lawsuit settlement must file a proof of claim showing that they suffered a loss typical of those included in the lawsuit. For example, in a class action lawsuit alleging that an insurance company overcharged customers, a proof of claim would detail the dates a claimant was insured by that company. Once the claims administrator examines all proofs of claims, she may make distributions. This process can take more than a year. Class action members typically receive a small check in the mail.
Taxable Class Action Settlements
Most class actions involve economic or contractual claims that are fully taxable. For example, the 10 most recent class action lawsuits on Class Action World as of March 2011 include eight lawsuits alleging securities violations (deceptive practices affecting stock markets) and two lawsuits alleging antitrust violations (actions limiting competition in a market). IRS Publication 525 advises taxpayers to consider other economic claims like copyright infringement, breach of contract or interference with business operations as ordinary taxable income.
Class Action Settlement Examples
Eva Rosenberg, a tax professional writing for Equifax, notes that tax treatment of class action settlements is highly dependent on the nature of the claimant's damages. She explains that women suffering cancer because of a plant's toxic emissions were entitled to tax-free settlements in a class action because they suffered physical injury. Conversely, Los Angeles bus drivers settling a wage claim against a school district paid taxes on their settlements because the claims were economic in nature and did not arise from a physical injury.
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