Do I Have to Pay Taxes on a Lawsuit Settlement?

If you’ve been involved in a lawsuit or settlement and have been awarded a sum of money, you might think that money is yours to spend, free and clear. You’ve paid back the entitled parties, your lawyer got his or her cut, and now you’re ready to buy yourself something nice!

Unfortunately, the IRS is also waiting for their portion of your settlement. You might not even realize that you owe taxes on your lawsuit settlement until you receive a 1099 at tax time. Depending on the type of lawsuit and the types of damages awarded, a portion or potentially all of your settlement funds could be taxed as income.

If you’ve been awarded funds from a legal settlement, it would be smart to use a portion of that money to pay an experienced accountant for tax preparation services to make sure that your settlement is taxed correctly. Your accountant can make sure that your tax return is properly prepared; and if you are unable to pay your tax bill, they can help you with payment options.

When Do You Owe Taxes on Lawsuit Settlements?

The General Rule

The general rule is that lawsuit settlements are taxable, except in cases that involve an actual, physical injury (“observable bodily harm”) or illness that you suffered. In other words: personal injury settlements usually aren’t taxable, while other types of settlements usually are.

However, the settlement agreement can award money for different types of damages, so it is possible to owe taxes on a portion of the full amount.

Specific 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 the physical injury settlement award includes damages for emotional distress, those funds are also nontaxable—again, as long as they are directly related to a physical injury that you sustained.
• Physical Sickness: Settlements related to physical symptoms, like chemical exposure that causes illness and medical expenses, are nontaxable.
• Medical Expenses: Lawsuit settlements for medical expenses are nontaxable, unless you previously deducted those expenses on your taxes. You can’t take the same tax break twice.

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 do not involve 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 sometimes awarded to punish a defendant, rather than compensate victims for specific losses (such as medical bills, lost wages, or pain and suffering). The defendant pays punitive damages if they’ve done something grossly negligent, reckless, or malicious. Punitive damages are always taxable, even if they are part of a personal injury settlement.
• Legal Fees and Attorney Fees: If your settlement is taxable, you still owe taxes on the full amount of the settlement—before legal fees and attorney fees have been deducted. This means you will technically pay taxes on your legal fees and attorney fees. More on legal fees below.

The Gray Area of Settlement Proceeds

Taxes on settlements are often not clear cut. Your personal injury settlement may involve some punitive damages, settlement interest, or compensation for medical expenses that you already claimed deductions for in a prior tax year. If this is the case, you may owe taxes on a small portion of your physical injury settlement payments.

Conversely, you may have been the plaintiff in a wrongful termination lawsuit, and the emotional distress of the wrongful termination may have caused you physical sickness. Your doctor’s bill for the resulting migraines may be part of the settlement payment, and that portion would not be taxable. However, emotional distress damages that do not involve physical symptoms are still taxable.

How to Report Income From Lawsuit Settlements On Your Taxes

Most settlement proceeds get the same tax treatment as ordinary income. You should receive a 1099-MISC from the insurance company that paid the settlement and should add that to your tax return in the appropriate box. Lost wages may result in a W-2 tax form for reporting purposes. You may also receive a 1099-INT if you received judgment interest.

If you use tax software to file your tax return, it should prompt you on how to enter these amounts. However, taxes can be complicated, and the benefits of a tax accountant are numerous. If you have any questions, or if you think there are errors on the tax forms you received following a lawsuit settlement, the help of a tax lawyer can be invaluable.

There are ways to avoid paying taxes if the lawsuit is still ongoing. A little tax planning can save you money, even on personal injury cases. For instance, if you have a large taxable amount, like punitive damages, you might be able to get that money reallocated to a tax-free amount like personal physical injuries.

In addition, whether you accept a lump sum payment versus monthly settlement payments can make a big difference in what taxes you will owe. A large windfall can put you into a higher tax bracket. A common misconception is that this will increase the taxes on all your regular income as well, but in reality, you only pay a higher percentage on any amount that is above the tax bracket threshold. An experienced accountant can give you tax advice to help you with settlement negotiations for tax purposes.

RELATED: Determining Income Type, Differences With Earned & Unearned Income

Legal Fees

If you hire a contingent fee lawyer, and you are awarded taxable damages, you may be surprised by your tax bill. The contingent fee cut is often taken out of your settlement money before you receive it, but you should expect to be taxed on the entire amount.

This may result in higher taxes than you expected, because you may have expected to only owe taxes on the amount you received. This can be very stressful, especially if you do not realize it until tax time the following year.

Tax planning is essential if you receive funds from legal settlements.

RELATED: The Benefits of Year-Round Tax Planning and Organization

Contact S.H. Block for Tax Help With Your Lawsuit Settlement

If you are in the middle of a legal settlement, or if you have recently received settlement damages, it’s important to start your tax planning now. If your funds are coming from personal injury settlements, you may still want to have a tax attorney look over the settlement to make sure all the damages are tax free.

Our team is very familiar with how lawsuit settlements are taxed and will give you our honest advice about how to approach your annual tax return. We can set up a free consultation to learn more about your settlement, just give us a call at (410) 872-8376 or fill out this online form and we can take a look at the details of your case.

The content provided here is for informational purposes only and should not be construed as legal advice on any subject.