Typically, people go to small claims court in pursuit of a settlement for damages they have suffered. Getting a payment is great news, but you need to be aware that certain payments may be taxable. Here's what you need to know about taxes and small claims settlements.
1. The IRS considers most payments as income.
Almost every payment you receive is considered income by the IRS. There are limited exceptions to this rule — gifts, inheritances, and life insurance proceeds. Ergo, if you receive a settlement in small claims court, you should be aware that it is likely to be considered taxable income.
2. Two types of settlements are not taxable.
The IRS does not consider settlements for certain discrimination claims or claims related to physical injuries to be taxable. Physical injuries also include sicknesses, but it does not include emotional injuries unless they were a byproduct of the physical injury.
If you receive settlements for either of these types of claims, they should not be taxed. In some cases, your settlement may be based on multiple factors. Some of it may be taxable, and some of it may not be.
3. You may receive a 1099-MISC.
After you receive the settlement, the entity that paid the settlement will send you a 1099-MISC. This is just a tax form used to report all kinds of different income such as interest on the 1099-INT or non-employee compensation on the 1099-NEC.
Generally, you will only receive a 1099-MISC if you have received a small claims settlement of over $600.
4. The 1099-MISC may trigger a filing obligation.
The amount on the 1099-MSIC is the amount you need to report on your tax return. Generally, you don't have to file a tax return if your income is under the standard deduction ($12,550 for a single person in 2021). However, this threshold applies to earned income.
The threshold for freelance income or unearned income such as the amount you received in small claims court is just $400. As a result, if you are a low-income person who normally doesn't file a return, you may need to file the year you receive a settlement.
5. You may be able to deduct expenses.
In some cases, you can deduct certain expenses from the settlement income. Here's an example: imagine that you are a landlord who went to small claims court after a tenant stopped paying the rent. You received a settlement for the back due rent.
In this case, you have to report the income from the settlement just as you do your regular rental income. But you can also deduct your expenses for being a landlord just as you would from the regular rental income that you receive.
To learn more about small claims, contact a financial professional such as Alaska Cascade Financial Services.