Are Lawsuit Settlements Taxable?

Gabe Levin | May 1, 2021 | Personal Injury
Are Lawsuit Settlements Taxable?

At last, you settle your lawsuit. Most lawsuits try to make a plaintiff whole after an injury or other loss. Part of your settlement agreement provides that the at-fault party pays you compensation for your losses. You can’t wait to receive money to cover the cost of your injuries and make plans for the future, but do you have to pay taxes on the money you receive from a lawsuit settlement?

As with any tax question, the answer is complex and confusing. Every case is different, but depending on the nature of the claim and other circumstances, you may have to pay taxes on the settlement payout that you receive. Here are some general tax guidelines; however you may need to consult a tax expert regarding your case because the IRS has determined that lawsuit settlements are taxable under certain, complicated circumstances. Read on for more information regarding the tax requirements of personal injury settlements.

Types of Lawsuit Settlements

As to terminology, a judgment refers to a formal court resolution of a dispute, in which the court may order one party to pay money damages to another. Settlement refers to a mutual agreement between litigants. Settlements are a different process than adjudication by a court, binding arbitration, or other types of formal hearings. However, for tax purposes, judgments and settlements are treated in the same way.

The general rule of taxability for amounts received from the settlement of lawsuits and other legal remedies is Internal Revenue Code (IRC) Section 61, which states that all income is taxable “unless a specific exception exists from whatever source derived unless exempted by another section of the code.”

Some types of compensation are almost always taxable, such as:

  • Interest on monetary awards
  • Most payments for lost wages or lost profits
  • Damages for patent or copyright infringement or breach of contract
  • Money received for settlement of pension rights

Perhaps the biggest exception to that rule comes into play with settlements to compensate for personal injuries. The IRS excludes some income from lawsuits, settlements, and awards from taxation—but not all of it.

What occurred that gave rise to the settlement? What are the facts of the case, and what is the purpose of the money? The issue is, what was the compensation received intended to replace?

If you get a settlement from a lawsuit, it could be for one of several reasons. Your settlement may constitute compensation for losses resulting from a physical injury or damages from another type of injury. Some or all of the compensation may arise from various kinds of emotional distress or punitive damages awarded by the court because of the defendant’s egregious conduct.

Origin of the Claim

The facts and circumstances of every case are different. As a general rule, the Internal Revenue Service (IRS) taxes settlements based on the origin of the specific claim, which depends on the reason for the claim that formed the basis for the settlement.

A lawsuit that arises from an injury that occurred in an accident may have more than one type of damage claim. Some of these are taxable, while others are not. In certain business disputes, the IRS taxes a settlement for lost profits as ordinary income. Depending on circumstances, an award for lost wages, wrongful termination, or severance may be taxable as income. If you win compensation for damages to your home caused by a negligent builder, instead of taxable income, the IRS may treat that compensation as a reduction in your purchase price of the property. Clearly, the intricate rules are full of exceptions.

Are Personal Injury Settlements Subject to Tax?

The simple answer to this question is: no. Personal injury settlements are not taxable if they demonstrate observable bodily harm. So, if the injuries are visible or physical, the IRS treats settlement money that resulted from those injuries as nontaxable and excluded from the income section of your tax forms.

Therefore, if you sue after being physically injured, such as in a car crash or other type of personal injury, the IRS treats the compensation that you’d receive after settling as non-taxable. Note that this does not include punitive damages, which the federal government taxes. The tax status of personal injury settlements can prove confusing because the compensation in personal injury cases often includes reimbursement for losses, such as lost wages, that would otherwise be taxable.

Regardless, as long as the origin of a claim arises from a personal physical injury or a physical sickness, those compensatory damages are tax-free under Section 104 of the tax code. However, if you deducted any of your medical expenses in prior years, you must report settlement funds as income because you cannot use the same tax break twice.

Examples of non-visible injuries are sexual harassment, slander, or defamation. Emotional distress is different from non-visible injuries but handled similarly.

Compensation for Emotional Distress

Recoveries for physical injuries and physical sickness are tax-free, but symptoms of emotional distress are not physical. This area of the law becomes very complicated. Did the physical injury cause emotional distress, or did the emotional distress cause the physical symptoms? Simply put, if the defendant caused your physical injury, it is a tax-free event, but if emotional distress made you physically sick, that is likely taxable.

Before 1996, no personal damages were taxed. Therefore, settlements from claims such as emotional distress and defamation were tax-free. However, since 1996, only settlement money for physical injuries is nontaxable. Compensation for emotional distress is not taxed only if it originated from a personal physical injury or physical sickness.

Although emotional distress damages are generally taxable, the amount you must include in your taxes decreases by:

  1. Amounts paid for medical expenses attributable to emotional distress or mental anguish not previously deducted, and
  2. Previously deducted medical expenses for such distress and anguish that did not provide a tax benefit.

Sometimes, determining the taxable status of a settlement award is difficult. For example, in Domeny v. Commissioner, the plaintiff had multiple sclerosis. Her condition worsened due to workplace stress. Her employer discharged her, which caused further deterioration in her condition. She settled her employment case.

Ultimately, the Tax Court ruled that the plaintiff’s illness had worsened because of her employer’s actions, and therefore, some of her settlement was tax-free. The Tax Court said the IRS’s assertion that an individual can never have a physical injury or physical sickness in a claim for emotional distress was incorrect.

Courts have distinguished between signs of emotional distress and symptoms of emotional distress. A symptom is “subjective evidence of disease of a patient’s condition.” Emotional distress, on the other hand, may involve physical symptoms, such as stomach pain, headaches, and stomach disorders, but these are generally not considered physical injuries or physical sickness. In contrast, a sign is evidence perceptible to the examining doctor.

Punitive Damages

In some circumstances, a court may award punitive damages. Courts award these damages as a form of punishment for those found responsible by the lawsuit. Typically, courts award punitive damages when a defendant’s actions involve outrageous behavior, such as fraud, malice, recklessness, or complete disregard for the rights and interests of the plaintiff. They are not awarded as compensation for the injured party’s losses and are separate from the compensatory losses.

Punitive damages are generally taxable; however, it depends on the state. For example, personal injury lawsuit settlements, including punitive damages, are not taxable under Pennsylvania personal income tax law.

Attorney Fees

Attorney fees are another complex area concerning the taxation of lawsuit settlements. If your attorney represents you in a personal injury lawsuit on a contingency fee basis, you may pay taxes on 100 percent of the money recovered by you and your attorney. This is true even if the defendant pays the contingency fee directly to your personal injury lawyer. If your settlement is not taxable, such as a settlement resulting from injuries received in a car crash, you shouldn’t face any tax difficulties.

If your recovery is taxable, the situation is more complicated. For example, if you settle a lawsuit for emotional distress. Your settlement awards you $200,000. If your attorney fee is $80,000, you take home $120,000. Logically, you might think that you have $120,000 of income to claim on your taxes. However, the IRS says you must claim the entire $200,000.

In Commissioner v. Banks, the United States Supreme Court ruled that a plaintiff’s taxable income is generally equal to 100 percent of his or her settlement. This is the case even if their lawyers take a share. Furthermore, in some cases, you cannot deduct the legal fees from your taxable amount.

Allocating Damages Can Save Taxes

Naturally, you want to do everything possible to minimize the tax consequences of a settlement. There may be opportunities for tax planning when negotiating a settlement, although settlements are subject to challenge by the IRS. In determining whether you received some or all of the settlement because of physical injury or illness, the IRS looks at documents such as the pleadings, the negotiations, and the actual settlement document.

The tax language used in a settlement agreement is not binding on the IRS or the courts in later tax disputes, but the document should be as specific about taxes as possible. Most legal disputes involve complicated scenarios and multiple related issues. Even if your dispute relates to the primary issue, the settlement may actually involve more than one consideration.

When the parties agree on tax treatment, although it is not binding, the IRS considers the parties' intent when determining whether it will exclude a settlement from tax. If the settlement agreement does not address taxation, the IRS will look to the intent of the payer to determine the tax status of the settlement payments.

In some cases, it is possible to allocate damages between various claims. For example, some damages may go to physical injuries or illness, which are non-taxable. Others may pay for emotional distress, which generally is taxable.

To exclude a payment from income on account of physical illness or injury, keep all evidence related to the claim and any proof that the defendant was aware of the claim and considered it in making payment. Medical records can help establish that the defendant caused the injury or caused it to worsen. Declarations from the treating doctors, as well as medical experts, can prove helpful. All of this evidence is useful when dealing with an IRS query or audit.

Consider the possible tax implications when negotiating a settlement agreement and before you sign it. Once you have signed the agreement, you cannot change it.

Why Are Tax Considerations Important?

During a lawsuit, most people’s attention primarily focuses on the outcome and the amount of the awarded compensation. In the relief of an anticipated recovery, people may not consider the taxes you may need to pay on the settlement amount.

By now, you have probably taken on countless challenges, including enduring a painful recovery and financial losses. You and your attorney have fought long and hard for compensation that covers the full cost of your injuries. After dealing with the physical and financial recovery from an injury, the last thing you want is to deal with the IRS. The goal is for you to retain as much of your settlement amount as possible to aid in your recovery.

It can be tricky to determine the taxation of your settlement, so it is essential to stay involved in this last step of your lawsuit settlement. Of course, there are general rules regarding how much you will pay in taxes on the settlement amount. However, you should discuss the situation with your attorney and a tax professional for guidance, as there may be things you can do to reduce your taxable income. For more information, reach out to an experienced personal injury attorney today.