What You Need to Know About the Taxation of Lawsuit Settlements
Taxation on settlements primarily depends upon the origin of the claim. The IRS states that the money received in a lawsuit should be taxed as if paid initially to you.
For example, if you sue for back wages or lost profits, that money will typically be taxed as ordinary income. If you receive a tax-free legal settlement agreement for personal injury or physical sickness, you are not typically taxed on those settlement proceeds as those monies are deemed to make you whole after an accident.
Before 1996, all personal injury settlements were tax treatment recoveries, including physical, defamation, and emotional distress personal injuries. However, also since 1996, to receive a tax-free recovery, your injury must be "physical."
The IRS has not defined "physical" for this purpose of the tax benefit. However, the agency has shed some light on what is deemed physical by stating that you must have "visible harm" for an injury to be considered physical.
Any damages related to emotional distress and any resulting symptoms of emotional distress, such as headaches or stomachaches, are no longer tax-free recoveries; instead, these damages are taxed as they are not considered "physical."
Some lines are unclear here with the definition of "physical." For example, if your work environment caused you migraines, would your headaches be considered a physical condition, or would they be a result of emotional distress damages inflicted by your employer? Often, these blurred lines are offered up in an argument by your attorney. However, if a Form 1099-MISC for legal fees is provided to you for all or some of your settlement agreement, any attorney arguments become void, as legal proceeds reported on the Form 1099 are deemed taxable income.
Other settlement proceeds that may not be taxable income are previously deducted medical expenses and attorney fees, even if they are related to emotional injuries. Reimbursement for medical expenses is a tax benefit. If your case involves sexual harassment and abuse, then another set of tax laws applies.
Finally, punitive damages, wrongful death, emotional stress, car accident or non-physical injuries and attorney fees are always tax-deductible. For example, in a car accident case where you sustained injuries, you may receive a settlement for your physical injuries, often called compensatory damages, and you may receive damages if the other party's behavior and actions warrant such an award. Although these damages are tax-free, the damages are fully taxable as they relate to your sustained physical injuries.
What's the Difference Between Taxable and Non-Taxable Settlements?
Lawsuit settlements are typically separated into 2 categories: taxable and non-taxable. There are tax implications to every rule and each lawsuit claim is unique, which is why we suggest seeking advice from an experienced attorney wherever possible.
According to the Internal Revenue Service (IRS), gross income includes “all income from whatever source derived,” which means almost every penny earned in a settlement payment is taxable, except from personal injury cases and physical injury claims 26 U.S.C. Â§ 61(a).
4 Non-Taxable Settlements
1. Physical Injury / Personal Injury Settlements
The IRS does NOT tax settlement awards from personal injury lawsuits if these cases demonstrate “observable bodily harm.” So, if the injuries are visible, the government considers settlement money that was awarded because of those injuries, tax-free. Do not include these settlements in the income section of your tax forms.
2. Car Accident Injury Settlements
Any of the major claims a car accident lawyer settles will almost always be non-taxable. Cases handled by personal injury lawyers are an exception to any settlement awards that are considered income.
If a lawyer chooses to work on a contingency-fee basis, those fees can be taxed. However, that is not the case with car accident cases or many other personal injury cases like slip and fall or workers compensation. Those contingency fees will not be taxed.
Do not include these settlements in the income section of your tax forms, unless you have also incurred medical expense reimbursement from the previous year.
3. Emotional Distress Awards
Any settlement money received for emotional distress is non-taxable, if and only if the distress or anguish originated from the personal physical injury or sickness caused by the accident. However, remember that any medical expenses incurred will be subject to the rule above and itemized deduction will be taxable when the settlement is reached.
4. Pain and Suffering
You do not have to pay taxes on pain and suffering, along with emotional distress directly caused by a physical injury or ailment from an accident.
However, if there were no physical injuries, and the basis of the lawsuit is related solely to the harm being mental or emotional distress, those damages will likely be taxed both by the state and the IRS.
2 Taxable Legal Settlements
1. Punitive Damages / Interest
Punitive damages are awarded by a judge or jury as a punishment that the defendant pays when their actions were especially heinous or showed complete and utter disregard for human life. These types of damages are meant to deter others from doing the same egregious acts.
Punitive damages are not common in personal injury lawsuits. However, it’s essential to know the tax consequences they have on a settlement or payout. In many states, punitive damages can be subject to taxation by both the state and the IRS.
Because damages are taxable and compensatory damages are not, it is important to be specific in determining each classification of damages that you’ve been awarded in a personal injury claim.
Your settlement must specify the amounts that are awarded to either types of damages. If a significant portion of your settlement is awarded for damages, you can expect to have high tax consequences that can drastically alter the final payout.
2. Lost Wages
Lost wages are considered taxable because wages are income that would have been taxed if it were received without interruption. Not only will income tax be added by a tax professional, but these wages are also subject to social security taxes and Medicare tax.
Advice on Your Lawsuit Settlement
If you were hurt in an accident caused by another party’s negligence, the legal process could often take months or years before a settlement can be reached. When you receive financial reimbursement for all the expenses and costs you sustained since the accident, it'll likely come as a huge relief.
However, it’s important not to rush the negotiation process until you’re confident, not only in the amount offered but also the way the settlement is structured.
Before signing any final settlement offers, be sure you understand what portions of the payout are taxable. If you’re not careful, a poorly structured settlement offer can cost thousands of dollars in taxes alone.
Be sure to consult with an experienced personal injury lawyer before any offer is accepted. Consulting with a knowledgeable attorney with extensive experience in personal injury can help you get the most of your settlement and remove any unnecessary tax liability.
- Is a Personal Injury Settlement Taxable?
- When Are Settlements Public Records?
- What Are Punitive Damages?
See all related personal injury lawsuits our team has been covered.
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