Each year I am asked numerous questions regarding the taxability of certain forms of income.  In the following article I am going to address legal settlements and income from bonds.

Legal Settlements

One of the more common questions I encounter and certainly one of the most confusing pertains to the taxability of legal settlements.  The rules I lay out here are general and all legal settlements should be reviewed due to the complexity of this area.

The first general rule is that damages received as a result of physical injuries are excludable from income.  Punitive damages awarded are taxable income.

Damages received as a result of emotional distress or other nonphysical injuries (such as employment discrimination) are taxable income unless they stem from a physical injury.  In other words, if an individual receives a settlement because of employment discrimination this would generally be taxable income.  If an employee, however, was injured on the job and the settlement covered medical expenses and lost wages the settlement would be excluded from taxable income as the lost wages were a direct result of a physical injury.

There is also a question as to whether legal settlements may be reported net of legal fees.  The general rule is netting is not permitted.  No legal fees are deductible if the damages awarded are not taxable.  If a settlement contains both a taxable and nontaxable portion (i.e.  Damages related to a physical injury which are not taxable and punitive damages that are taxable) then legal fees must be allocated in the same ratio as the settlement and only the portion relating to taxable income is deductible.  Even once it is determined that legal fees are deductible there are a couple of different ways that the fees are deducted depending on the particular situation.

Bonds

Bonds are another form of tax exempt income that tend to cause confusion.  Since I am located in New Jersey I will concentrate on the federal and New Jersey taxation of bonds.

Interest from state and local government bonds are exempt from federal tax.   Dispositions of these tax exempt bonds resulting in a gain are taxable for federal purposes.  Interestingly enough income from federal obligations such as US Savings bonds, treasury bills, notes and bonds are taxable for federal purposes.

New Jersey, on the other hand, exempts all federal obligations from taxation.  In addition obligations of the State of New Jersey or any of its political subdivisions are exempt from taxation.  Obligations of other states are generally subject to taxation.

Conclusion

This article explains some basic concepts regarding legal settlements and bond income.  There are exceptions to the above general rules and you would be well advised to speak to a professional well versed in these areas.