Tax Treatment of Class Action Settlements

If you're party to a class-action lawsuit, you've joined with other plaintiffs in a claim against a defendant for fraudulent, misleading or reckless conduct. Most class-action cases settle before reaching trial, allowing plaintiffs a share in the judgment against the defendant. Since the money is not, strictly speaking, compensation for specific losses on your part, the award, in most cases, is "punitive" and taxable.

Class-action lawsuits typically allow a large group of plaintiffs to claim damages against a corporation for illegal or fraudulent business practices. In one example, T-Mobile was sued for overcharges on its premium SMS or text messaging services. The settlement amounted to a credit of $40 for anyone who could prove she was billed by the company for these services. Websites dedicated to class actions offer a list of current and pending suits, the amount offered in settlement, the requirements to make a claim and contact information to file a claim.

In class-action lawsuits, plaintiffs share any awards equally; the money in most cases does not compensate them for a unique, personal loss. With some exceptions, the Internal Revenue Service classifies these awards as punitive: They are meant only to punish the defendant for a wrongful action. They're taxable, as are interest, payment for defamation of character or libel, compensation for lost wages and payment for any expenses that have been deducted for tax purposes. In contrast, compensatory damages make the plaintiff whole for his own loss -- medical bills paid (but not reimbursed) for a physical injury, for example, or legal fees paid to pursue the case.

The IRS requires reporting of any payments of more than $600 on a class-action settlement on a 1099-MISC, for miscellaneous income. The payer checks Box 3 of this form to report punitive damages as well as damages for nonphysical injuries, such as emotional and mental anguish. The individual who receives a class-action award must report any and all income received on Line 21 of Form 1040, for miscellaneous income. This amount is included in adjusted gross income and is taxable.

If a class-action lawsuit deals with actual physical injury or illness, for which you incurred medical and other expenses, the IRS treats the proceeds as compensatory. An example would be a company sued by residents living near a factory who have suffered cancers as a result of industrial emissions. In addition, in a financial case, settlement that compensates a plaintiff for loss of investment money could be subject to capital gains taxes if the original investment has increased in value. If you've joined a class-action suit, consult a tax professional about the proper handling of any proceeds.