Are Lawsuit Settlements Taxable?

So, you’ve won a legal battle regarding a personal injury and are about to receive a settlement. It’s a celebratory moment, but don’t forget about an important party that might be involved – the IRS. Taxes on lawsuit settlements can be confusing. The tax you pay on your settlement money may vary depending on the type of lawsuit and the damages awarded. In some cases, you may have to pay taxes on all of your settlement money.

It is imperative to seek a professional’s assistance to advise you on what to expect. At The Barnes Firm, our personal injury attorneys can offer valuable insight into the proper steps following lawsuit settlements.

The General Rule About Taxes on Lawsuit Settlements

When it comes to lawsuit settlements and taxes, the general rule is that the IRS treats them as income. This means that the proceeds from a lawsuit settlement are taxable in most cases. There is one critical exception to this rule, however – settlement proceeds related to physical injuries or illnesses typically are not taxable.

This includes personal injury settlements, emotional distress claims tied to physical injuries, settlements for physical illness, and medical expense settlements.

Settlements stemming from non-physical lawsuits, emotional distress without physical injury, lost wages and back pay from non-physical injuries, interest on settlements, punitive damages, and legal fees are usually taxable.

When are Lawsuit Settlements Proceeds Non-Taxable?

• Physical Injury: Lawsuit settlements stemming from physical injuries are typically considered non-taxable. This includes cases like personal injury claims resulting from accidents, car collisions, or other incidents causing observable bodily harm.
• Emotional Distress: If a settlement involves damages for emotional distress directly related to a physical injury, these proceeds are generally not subject to taxation. In such cases, the emotional distress is considered an extension of the physical injury.
• Physical Sickness: Settlements associated with physical sickness or illness, such as those arising from chemical exposure, are typically considered non-taxable.
• Medical Expenses: Lawsuit settlements intended to cover medical expenses are usually non-taxable. However, if you’ve previously deducted these expenses from your taxes, you cannot claim the same tax benefit twice.

It is important to understand these categories when it comes to determining the tax treatment of lawsuit settlements. While these types of settlements are typically non-taxable, we advise our clients to consult with a professional to ensure accurate compliance with IRS regulations.

Which are Taxable Settlement Proceeds

The taxability of settlement proceeds depends on the nature of the underlying lawsuit or claim. The following damages are usually taxable:

• Legal Fees and Attorney Fees: Legal fees paid to an attorney are typically deductible if they are related to a taxable settlement. However, the deduction might be subject to certain limitations.
• Punitive Damages: Punitive damages are usually considered taxable. They are awarded to punish the defendant for their actions rather than compensating the plaintiff. You’ll likely need to report them as income.
• Pre- or Post-Judgment Interest: Interest received on a settlement is generally taxable as interest income. This includes both pre-judgment and post-judgment interest.
• Lost Wages and Back Pay: A settlement for lost wages or back pay related to a non-injury lawsuit is typically treated as taxable income. This may include issues like employment discrimination or wage theft.
• Other Non-Injury Lawsuits: Settlements for non-physical lawsuits, such as employment disputes, defamation, or contractual disagreements, are usually taxable. You should report these amounts on your tax return.
• Emotional Distress: Emotional distress damages received from a non-physical lawsuit may be taxable, but there are exceptions. If the distress is directly related to physical injuries or sickness, it might be non-taxable.

Some settlements don’t neatly fit into the taxable or non-taxable categories. For example, a personal injury settlement may feature elements like punitive damages or interest subject to taxation. On the other hand, a wrongful termination lawsuit could include emotional distress that leads to physical illness, making certain portions of the settlement not taxable. In such cases, seeking the counsel of a tax professional becomes vital for determining the proper tax treatment.

When Are Legal Settlements Taxable?

A settlement compensates an accident victim for their injury-related losses. Some of the damages an injured victim obtains include medical expenses, lost income, pain and suffering, and loss of enjoyment of life.

Although injured victims are entitled to both economic and non-economic damages, settlements are in monetary form. Most importantly, injured victims obtain compensation in one of two ways: a settlement or court award.

Through the settlement process, both parties may reach an agreement through negotiations or mediation without going through the trial. Alternatively, a jury may order the at-fault party to pay damages in a trial after examining evidence and determining a fair settlement amount.

Despite the differing paths to obtaining damages for injury-related losses, the tax implications of a settlement and a court award are similar. 

Legal settlements are often taxable, depending on the nature of your case.

Here is a brief on the application of tax:

• Physical injury settlement: Suppose you received a settlement after sustaining a broken arm in a car accident. In that case, the settlement amount is tax-exempt unless you deduct medical expenses related to the injury on a previous tax return that you accrued a tax benefit from the deduction.
• Punitive damages are taxable.
• Damages for mental distress and emotional anguish are taxable unless received for a physical injury. 

What Do I Need to Know When Filing Taxes After My Settlement?

Treatment of a Judgment During Taxation

The Internal Revenue Service treats a settlement the same as a judgment. As such, expect a similar tax application whether a judge or jury determined the damages or you entered into an agreement with the insurer of the at-fault party.

Is it Possible to Owe Taxes to the Local or State Government?

Yes. While many injured victims think of taxes they could owe to the federal government, there is a possibility of having a state tax bill. In some instances, you could be charged at a local level.

As such, consider speaking to an accountant on ways to reduce your tax obligation. Work closely with an accountant on possible taxes that could significantly impact the value of your personal injury settlement.

You Could Reduce Tax Liability With the Right Techniques

There are ways you can minimize the overall tax bill, including:

• Structuring your settlement which allows you to receive it for a few years, consequently reducing your tax bill
• Using exemptions and deductions to reduce your tax burden
• Creating an itemized list of your losses, which makes it clear on the applicable tax rates

The Gray Area of Settlement Proceeds 

Pain and suffering damages arising from a physical injury are a form of non-economic damages and are not subject to taxation. However, there is a distinction in the application of emotional pain and suffering because of a physical injury. 

If the basis of the lawsuit is purely based on mental or emotional distress, then the injured victim who receives a settlement may be subject to taxation. Further, if the lawsuit is based on a physical injury or ailment, the pain and suffering damages are exempt from state and federal taxes.

How Do I Report Income From Lawsuit Settlements On My Taxes?

First, identify the nature of the lawsuit settlement. Is it related to physical injuries, non-physical issues, punitive damages, emotional distress, or lost wages? Your tax payment on the settlement process will depend on the type of settlement.

• Consult a Tax Professional: It’s advisable to consult a tax professional or attorney who specializes in tax law. They can support you based on your specific situation and help you understand the tax implications.
• Completing IRS Forms: You will typically need to complete relevant IRS forms to report the settlement income. The specific form depends on your situation. For example, if you received a settlement related to physical injuries, you might use IRS Form 1040 and report the income on Schedule 1.
• Keep Documentation: Maintain records and documentation related to the lawsuit and settlement. This includes copies of the settlement agreement, legal fee receipts, and relevant correspondence. These documents can be important for substantiating your tax reporting.
• File Your Tax Return: Include the lawsuit settlement income on the appropriate line of your tax return, as instructed by your tax professional or tax preparation software. Pay any taxes owed based on this income.

For tax purposes, you must report the entire settlement amount as income, including the portion that goes to your attorney as a contingent fee. Your attorney’s fee is usually deducted from your settlement or award before you receive the settlement.

Let an Injury Attorney Help With Your Lawsuit Settlement

Navigating the world of lawsuit settlements requires careful attention since you want to avoid any unforeseen financial consequences. To ensure you follow the right path, it’s highly recommended to seek guidance from an attorney who handles personal injury claims.

Our legal team at the Barnes Firm will provide guidance and ensure you correctly handle your lawsuit settlement. Contact our office today at (800) 800-0000 for a free case evaluation.

Richard Barnes – President of The Barnes Firm

Richard Barnes: “As President of The Barnes Firm, I have dedicated my career to achieving justice in hundreds of cases for the victims of injuries caused through the fault of others. Additionally, I have been honored to have been elected Best Lawyer and a Super Lawyer”

Years of Experience: 30+ years
LinkedIn Profile: Richard Barnes