Are Lawsuit Settlements Considered Taxable & What Should I File?

Most money awarded as a result of a lawsuit claim will be subject to taxes. The IRS is a governing body that exists to collect taxes, and that’s exactly what they do best: they collect taxes! To ensure you are following the tax codes and laws correctly, we suggest speaking with a professional accountant as soon as possible, especially if you stand to collect a large, 6 or 7 figure settlement.

 

Settlement money and damages collected from a lawsuit are considered income, which means the IRS will generally tax that money, although personal injury settlements are an exception (most notably: car accident lawsuits and slip and fall claims are nontaxable).

 

Lawsuit settlements and damages are generally separated into two categories: taxable and nontaxable. There are exceptions to every rule and each lawsuit claim is unique. Again, we suggest seeking the advice from an account where possible.  

Remember, according to the IRS gross income includes “all income from whatever source derived”. Which means almost every penny earned in a settlement is taxable, except personal injury and physical injury 26 U.S.C. § 61(a).

 

tax on lawsuit settlements

 

NONTAXABLE

Physical Injury Awards Are Usually Nontaxable

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 IRS 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 [3].

Car Accident Injury Settlements Are Almost Always Nontaxable

Any of the major claims a West Palm Beach car accident lawyer settles will almost always be nontaxable. Personal injury cases are an exception to any settlement awards that considered income. 

Remember, if a lawyer chooses to work for contingency fees (where the attorney collects fees after winning a case), 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 [2]. 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].

Medical Expenses Are Nontaxable If No Deduction Was Taken Previously

Medical visits for emotional distress or physical injury are nontaxable if you did not take an itemized deduction for these expenses in prior years. However, if you settle and are reimbursed for medical expenses after taking a deduction in previous years, you will be required to pay tax that year. This is a very specific IRS rule called the “tax benefit rule” [3]. Include these reimbursements in the “Other Income” section on line 21 of the 1040 Form.

Emotional Distress Awards Are Nontaxable

Any settlement money received for emotional distress is nontaxable if and only if the distress or anguish originated from the physical injury or sickness caused by the accident. However, remember that any medical expenses incurred will be subject to the rule above and deductions will be taxable when the settlement is reached [3].  

 

TAXABLE

Punitive Damages and Interest Are Taxable

This is where things can get somewhat complicated. Any pre-judgment or post-judgment interest on settlement money is taxable and may influence taxes on some attorney fees. The same can be said for any punitive damages awarded. We advise you speak to a professional accountant as soon as you can.

Lost Wages Are Taxable

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, but these wages are also subject to social security taxes and Medicare tax.

You can find all this information in the IRS Lawsuits, Awards, and Settlements Audit Techniques Guide


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Sources: [1]: How Are Lawsuit Settlements Taxed? [2]: Five Key IRS Rules On How Lawsuit Settlements Are Taxed [3]: Settlements —Taxability