Are Lawsuit Settlements Considered Taxable & What Should I File?

Most money awarded due to a lawsuit claim will be subject to taxes. The IRS is a governing body that exists to collect taxes, and collecting taxes is what they do best! 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. However, personal injury settlements are an exception (most notably: car accident settlements and slip and fall settlements are nontaxable).

Lawsuit settlements and damages can be arranged into two groups taxable and nontaxable. There are exceptions to every rule, and each lawsuit claim is unique. Again, we suggest seeking advice from an account where possible.

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

 

tax on lawsuit settlements

 

Nontaxable Legal Settlements

 

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 compensation money 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 major claims a car accident lawyer settles will almost always be nontaxable. Cases handled by personal injury lawyers are an exception to any settlement awards that consider income.
Remember, those fees can be taxed if a lawyer chooses to work for contingency fees (where the attorney collects fees after winning a case). However, that is not the case with car accident cases or 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 a tax that year; this is a 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 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]. Any emotional distress that is not caused by any physical injury from the accident will be taxable, so the distinctions must be made.

Taxable Legal Settlements

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 to speak to a professional accountant as soon as possible.

Lost Wages Are Taxable

Lost wages are considered taxable because wages are income that would have been taxed if they 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.

What Do You Need to Know When Filing for Taxes?

According to the IRS, determining how to file for taxes when you receive compensation takes the careful assessment. You need to identify how the settlement payment was processed to file correctly. You can do so by reviewing court-related documents or other relevant documentation of the settlement to figure out this information. It’s crucial whenever your personal injury case has been settled, you keep track of all documents concerning the compensation payment and make sure it doesn’t get lost.

The information needed about settlement payment:

  1. Was the payment placed as income, in whole or in part?
  2. Was the payment placed as wages, in whole or in part?
  3. Do you have the proper reporting requirement forms, 1099 or W-2?
  4. Did you receive settlement check(s) or scheduled payments?
  5. What was the amount of legal fees paid?

It’s also important to keep in mind that if you have two claims against a defendant and settle for both, indicate the amount for each. For example, if one claim is personal injury-related and the other is a non-personal injury claim, one settlement is excluded from taxation while the other is not. If you have no documentation about the amounts for each claim, the IRS will challenge the non-taxability of the settlement. It is so crucial to identify which settlement amount is personal injury-related, mainly because that settlement will, more often than not, be a more significant amount than the non-personal injury claim settlement. When you settle your case with your attorney, you can have the documentation specific to outline the different compensation amounts.


Sources:

[1]: How Are Lawsuit Settlements Taxed?

[2]: Five Key IRS Rules On How Lawsuit Settlements Are Taxed

[3]: Settlements —Taxability

About the Author

Michael Steinger
Michael Steinger

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MICHAEL S. STEINGER, founding partner of Steinger, Greene & Feiner, believes in representing real people, not big businesses. Since the firm’s creation in 1997, Steinger, Greene & Feiner has never represented an insurance company or large corporation, and he vows to keep this promise. Over the course of his career, Michael has handled thousands of Florida accident cases, recovering millions of dollars for his clients and earning him membership into the Multi-Million Dollar Advocates Forum. Staying up-to-date on the ever-evolving laws protecting injury victims and their families, Michael is an active member of the American Bar Association, the Palm Beach, and St. Lucie Bar Associations, and sits on the Auto Insurance Committee of the Florida Justice Association.