I won a lawsuit: Do I have to pay tax on my damage award?

The glow of victory may begin to dim after you get your attorney's bill. As if that disappointment isn't enough, we have more sobering news -- the IRS may try to claim its share of the total. So postpone that trip to Cabo, and read on.

According to the tax code, the only damages you can enjoy tax-free are those that compensate you for physical injury or physical sickness. (26 U.S.C. § 104(a).) So if this describes your case, you will probably keep the cash safely away from the grip of the IRS.

There are other reasons for awarding money damages besides compensating you for physical injury or sickness. For instance, let's say you had filed a discrimination claim against a former employer and won. You receive an award for back pay (the pay you would have received if the bum hadn't fired you) and for emotional distress arising out of this traumatic experience. Because none of this award relates to physical harm, almost all of it is taxable at ordinary income rates.

Another type of award is known as "punitive damages," which are intended to punish the defendant. Even if the underlying case resulted from injury or sickness, these damages are almost always taxable.

The IRS can rain on your parade in another, unexpected way. If you receive a lump sum payment for money you would have been entitled to if the defendant hadn't done you wrong, you may suddenly find yourself in a higher tax bracket. You know what that means: higher taxes.

To shed more light on this gloomy forecast, we recommend talking to a tax professional.