If you’re involved in a lawsuit, your attention is likely focused on physical recovery, meeting deadlines, discussing legal options with your attorney, and navigating the impact of the entire process on your family. You’ve endured significant losses, encompassing lost work time, pain and suffering, and accumulating medical bills.
The potential compensation at the end of this challenging journey is what you hope will cover expenses and help rebuild your life. What may not have been anticipated, however, are the taxable implications from the federal government.
The crucial question arises: Are lawsuit settlements taxable?
Keep reading to find out all you need to know about lawsuits that are taxable.
Table of contents
Are Lawsuit Settlements Taxable?
The IRS generally presumes that funds received from legal settlements are subject to taxation. Section 61 of the tax code stipulates that all received money, including funds from a legal settlement, is considered taxable income unless an applicable exception exists. Essentially, the IRS operates under the assumption that settlements are taxable unless proven otherwise.
The primary tax principle governing legal settlements is known as the origin of the claim rule. According to this rule, the taxes owed on a settlement are contingent on the initial reason for initiating the lawsuit.
Various types of compensation have different tax implications, with some being taxable income and others not.
For instance, if you’ve experienced a slip and fall accident resulting in a traumatic brain injury, a broken wrist, and missed work during recovery, your attorney may have presented arguments to secure compensation for lost wages, a permanent disability affecting your ability to earn, and pain and suffering arising from your recovery process and the stress of rebuilding your life. The elements for which you receive compensation can significantly influence the tax implications of your award.
READ ALSO: Inheritance Tax: Definition, Overview, How it works
Examples of Nontaxable Settlement Proceeds
The following categories of settlement proceeds are typically not taxable:
- Physical Injury: Payouts from personal injury claims, like car accidents or wrongful death lawsuits, are tax-free. This includes medical treatment costs and lost wages.
- Emotional Distress (Physical Injuries): If a settlement for physical injury incorporates compensation for emotional distress, those funds remain non-taxable, provided they are directly connected to a physical injury you experienced.
- Physical Sickness: Settlements related to physical symptoms, like chemical exposure that causes illness and medical expenses, are nontaxable.
- Medical Expenses: Settlements for medical expenses in lawsuits are exempt from taxes unless you have already claimed deductions for those expenses on your tax returns. The same tax benefit cannot be claimed twice.
Examples of Taxable Settlement Proceeds
The following categories of settlement proceeds are typically taxable:
- Non-Physical Lawsuits: In general, any non-physical lawsuit settlement is taxable. This includes wrongful termination suits, libel, property damage, discrimination lawsuits, and more.
- Emotional Distress (Non-Physical): Emotional distress damages that did not lead to a physical injury (for example, a wrongful termination, sexual harassment, or defamation) are taxable.
- Lost Wages and Back Pay (Non-Physical): Any wages awarded count as taxable income, again unless they were the result of a physical injury. In addition, these wages are subject to Social Security and Medicare taxes as well.
- Pre- or Post-Judgment Interest: Interest on the settlement is taxable.
- Punitive Damages: Punitive damages are occasionally granted not to compensate victims for particular losses (such as medical expenses, lost wages, or pain and suffering) but as a means to penalize a defendant for particularly egregious behavior, characterized by gross negligence, recklessness, or malice. Regardless of whether they are included in a personal injury settlement, punitive damages are always subject to taxation.
- Legal Fees and Attorney Fees: If your settlement is deemed taxable, you are required to pay taxes on the entire settlement amount, inclusive of legal fees and attorney fees, before any deductions. Consequently, you will essentially be paying taxes on the total settlement, which encompasses legal and attorney fees.
The Tax Benefit Rule and Personal Injury Settlements
The Internal Revenue Service (IRS) enforces specific regulations related to taxable income, including a concept known as the “tax benefit rule.” This rule becomes applicable when you receive a settlement that reimburses you for medical expenses previously deducted from your tax return in preceding years.
To illustrate, suppose you incurred significant medical expenses due to an accident or injury, and you claimed these expenses as deductions on your tax return in the previous year. If you later receive a settlement or lawsuit compensation that covers these same medical expenses, the reimbursement might be subject to taxation under the IRS “tax benefit rule.”
The underlying principle of this rule is straightforward: If you obtained a tax deduction for certain expenses in prior years (in this case, medical expenses) and subsequently receive compensation for those same expenses (via an insurance payout or legal settlement), that compensation must be reported as income on your taxes. The reasoning is that since the earlier tax deductions provided relief, the reimbursement essentially becomes a form of income.
In practical terms, this rule means that if you claimed $20,000 in deductions for medical bills last year and then received a $20,000 settlement covering those costs this year, the IRS considers that $20,000 as taxable income for the current year.
It’s important to note that only the portions of the settlement associated with previously deducted amounts would be taxable under this rule. Other components of the settlement, such as compensation for pain and suffering, emotional distress damages, loss of future earnings, etc., would follow their respective taxation rules independent of the “Tax Benefit” considerations.
READ ALSO: What is the Long-term Capital Gains Tax?
Are Income Taxes on a Settlement Taxable?
Income tax pertains to earnings from work, and the taxability of your settlement depends on its classification. If your settlement includes compensation for lost work time and future earnings, the money is considered income and is taxable. On the other hand, amounts awarded for physical or intangible losses, such as pain, suffering, and stress related to the incident, are not regarded as taxable income by the IRS.
Here is a list of what compensation the government considers taxable income in all types of legal matters:
- Interest earned on monetary awards
- Payments for lost wages and profits
- Damages for patent or copyright infringement
- Compensation for breach of contract
- Money received for settlement of pension rights
- Punitive damages
Income tax is associated with earnings derived from employment and the tax treatment of your settlement hinges on how it is categorized. If your settlement encompasses compensation for lost work time and future earnings, that money is recognized as income and is subject to taxation. Conversely, amounts granted for physical or intangible losses, such as pain, suffering, and stress linked to the incident, are not deemed taxable income according to the IRS.
SEE ALSO: Income Tax for California | Best List
What Isn’t Taxable In A Personal Injury Award?
Personal injury settlements typically remain exempt from taxation when they relate to observable physical harm, as defined in Section 26 of the U.S. Code, which outlines compensations subject to federal taxation.
However, if the emotional or psychological distress resulting from the claim leads to sickness, such as the impact of a breached contract causing business failure, the amount may be subject to taxes. The exception is when physical injury directly causes emotional distress. Consequently, a personal injury case is more likely to result in tax-free compensation for stress-related effects compared to a case involving emotional distress from matters like defamation or copyright infringement.
Various factors can affect your tax liability, including the amount already paid for medical expenses related to emotional distress that hasn’t been deducted. Moreover, medical expenses for emotional distress that were deducted but didn’t yield a tax benefit are considered tax-exempt.
Can Proper Planning Impact Whether You Have to Pay Taxes On A Settlement?
In the context of a car accident claim, an attorney has the ability to negotiate for a higher percentage of the car accident settlement to be directed towards conditions exempt from taxes rather than those subject to taxation. It is essential for your attorney to structure the settlement negotiations in a way that reflects the distribution of compensation, steering clear of a lump-sum approach that could be subject to interpretation by the IRS.
According to Section 61 of the Internal Revenue Code (IRC), all income is generally taxable unless there is a specific exception or exemption provided by another section of the code. Gross income, as defined by the IRS, encompasses all forms of income received, including money, goods, property, and services that are not exempt from taxation. In the context of settlements or court verdicts subject to taxation, any amount awarded through these legal processes that does not meet the criteria for tax exemptions is considered part of your gross income.
Effective planning and preparation play a crucial role in determining the vulnerability of your settlement to taxation. Despite the clarity in your settlement documentation, the subjective nature of your tax burden underscores the importance of your attorney’s diligent efforts to precisely define each component of the settlement. This proactive approach helps avoid potential subjective scrutiny by auditors, minimizing the risk of unexpected taxes and penalties.
Your attorney will be able to help you support this information in your claim, and you can present it to the IRS in the event of a query or audit. The IRS will consider the payer’s intent regarding what will be considered taxable and non-taxable in a settlement.
How To Report Income From Lawsuit Settlements On Your Taxes
Most settlement proceeds are treated as ordinary income for tax purposes. You should expect to receive a 1099-MISC from the insurance company responsible for the settlement, and it’s crucial to include this information in the appropriate box when filing your tax return. If the settlement involves lost wages, you might receive a W-2 tax form for reporting. Additionally, if there is judgment interest, you could receive a 1099-INT.
While tax software typically guides you through entering these amounts, tax matters can be complex, and the assistance of a tax accountant can be highly beneficial. If you have any uncertainties or believe there are errors in the tax forms received after a lawsuit settlement, consulting with a tax lawyer can be invaluable.
It’s possible to strategize to minimize taxes if the lawsuit is ongoing. Some tax planning can be advantageous, even in personal injury cases. For example, reallocating a large taxable amount, such as punitive damages, to a tax-free category like compensation for personal physical injuries can be explored.
Furthermore, the choice between a lump sum payment and monthly settlement payments can significantly impact the taxes owed. Receiving a substantial lump sum might push you into a higher tax bracket, but it’s important to note that the higher percentage is applied only to the amount exceeding the tax bracket threshold. Seeking guidance from an experienced accountant can provide valuable tax advice for negotiating settlements with tax implications in mind.
READ ALSO: 10 Ways for Getting the Biggest Tax Refund
Are Legal Fees Deductible in Lawsuit Settlements?
Typically, legal fees related to settlements from personal injury or sickness lawsuits are not deductible for tax purposes, as such settlements are generally considered non-taxable income. However, there are exceptions to this rule.
Legal fees connected to claims generating taxable income may be deductible. For instance, if you receive a settlement from a lawsuit related to discrimination or breach of contract (which are usually considered taxable events), the portion of the settlement designated as legal fees paid to your attorney might be deductible. This deduction can help offset your tax liability arising from the taxable part of your settlement.
It’s important to note that, due to changes introduced by the Tax Cuts and Jobs Act in 2017, deductions for most miscellaneous itemized expenses, including legal fees, have been eliminated for individuals through 2025. However, businesses can still claim these deductions.
In cases involving contingent-fee arrangements, where attorneys are paid based on winning the case and securing a percentage of the awarded compensation, it’s crucial to understand the IRS perspective on who technically “receives” the money first. According to IRS rules, if the funds are considered received directly by plaintiffs before being transferred to attorneys, it could potentially result in additional tax obligations for plaintiffs, even if they don’t directly receive those funds.
Therefore, comprehending the nuances of legal fee deductions in various types of lawsuits is essential during negotiations to determine the potential after-tax value of settlements. Additionally, post-award, when filing taxes, it ensures accurate declaration, minimizing the risk of audits or penalties.
FAQs On Are Lawsuit Settlements Taxed
To potentially minimize taxes, consider allocating the settlement amount to non-taxable categories such as compensatory damages for physical injuries. Consult with a tax professional for personalized advice.
It depends on the nature of the emotional distress. If it is directly related to a physical injury, the settlement is likely non-taxable. However, settlements for emotional distress unrelated to physical injuries may be taxable.
No, not all lawsuit settlements are taxable. The taxability depends on the nature of the settlement and the specific types of damages awarded.
Settlements that compensate for lost wages, punitive damages, and certain types of emotional distress unrelated to physical injuries may be taxable.
Conclusion
Just as you read in the article, some settlements are taxable, while others are not. Given the multifaceted nature of many lawsuits, the issue might not be straightforward. Without an attorney well-versed in how damages can be awarded, a substantial portion of what was intended to restore stability to your life might be claimed by the government.
References
- smartasset.com – How to Avoid Paying Taxes on a Lawsuit Settlement
- mdtaxattorney.com – Do I Have to Pay Taxes on a Lawsuit Settlement?
We Also Recommend
