If you have been involved in a lawsuit, you are probably focusing on your physical recovery, meeting deadlines, discussing your legal options with your attorney, and how the entire process has affected your family. You have suffered substantial losses, whether lost time at work along with pain and suffering, while the medical bills are stacking up.
The light at the end of the tunnel is the compensation you hope will cover your expenses and what you need to put your life back together. What you might not have anticipated, however, is the taxable implications from the federal government.
You need to know... Are lawsuit settlements taxable?
To make matters more confusing, some settlements are taxable, while others are not. Since many lawsuits are multi-faceted, the issue might not be simple. Without an attorney familiar with how damages can be awarded, the government might take a significant chunk of what was supposed to bring stability back to your life.
At the Levin Firm, we work closely with our clients to protect their rights. When discussing your case with a personal injury attorney, be sure to ask about taxation consequences from the initial consultation until the case is resolved.
How are Court Awards and Settlements Different?
The purpose of a lawsuit is to compensate an injured party for damages, which almost always happens through monetary means. The money at the end of the process will pay off medical expenses and property damages and help alleviate some pain and suffering. There are two typical ways a victim receives compensation: settlement or court award.
A judge or jury may order the wrongdoer to pay the victim for damages in a trial after hearing the evidence and determining fair compensation.
Through the settlement process, both parties reach an agreement through negotiation and possibly mediation. Without a jury trial's lengthy and expensive process, a settlement offers you more control and expedites the resolution of your claim. Most personal injury lawsuits never reach a jury trial because they settle instead.
The damages awarded can still be significant without the delay of multiple hearings, selecting a jury, or relying on a jury verdict or judge's ruling, which may be unpredictable. Settlements give both parties more control and can still result in significant compensation.
However, the tax implications of a settlement payment and court award are similar. In the eyes of the IRS, there is no distinction between the two; you may still be responsible for paying taxes on some of the compensation received.
Are Settlements Taxable?
Some forms of compensation are not taxable income, while others are. Due to the nature of a lawsuit—especially personal injury cases—many different elements go into the damages you can request in your case. For example, if you have been hurt in a slip and fall accident, you may suffer a traumatic brain injury, broken wrist, and missed time at work due to your recovery.
Your attorney might have argued your case with a need to compensate you for lost wages, a permanent disability affecting your livelihood, and pain and suffering due to your recovery and the stress of putting your life back together. Many elements of what you are compensated for impact how much you owe for taxes on your award.
The Tax Benefit Rule and Personal Injury Settlements
The Internal Revenue Service (IRS) implements certain rules regarding taxable income, one of which is known as the "tax benefit rule". This rule comes into play when you receive a settlement that reimburses you for medical expenses previously deducted from your tax return in prior years.
To elaborate, let's say you incurred substantial medical expenses due to an accident or injury, and you claimed these expenses as deductions on your tax return for the previous year. Later, if you receive a settlement or lawsuit compensation that reimburses those same medical expenses, this reimbursement could be subject to taxation under the IRS “tax benefit rule".
The principle behind this rule is straightforward: If you received a tax deduction from certain expenses in prior years (in this case, medical expenses) and then are compensated for those same expenses later on (through an insurance payout or legal settlement), that compensation must be reported as income on your taxes. The rationale is that since these later-reimbursed costs provided tax relief earlier, upon reimbursement, they essentially become a form of income.
In practical terms, implementing this rule means that if you took deductions worth $20,000 for medical bills last year and then received a $20,000 settlement covering those costs this year, the IRS views those $20,000 as taxable income in the current year.
However, only parts of the settlement linked with previously deducted amounts would be taxable under this rule; so any further compensation awarded within settlements, like pain and suffering or emotional distress damages; loss of future earnings, etc., would follow their respective taxation rules independent of 'Tax Benefit' considerations.
This IRS regulation can impact individuals who have claimed large medical expense deductions in past years only to later recover these costs through lawsuits or insurance claims. Therefore, it's crucial to consider potential implications by consulting your personal injury attorney about the potential tax liabilities involved in your case.
When Do You Have to Pay Taxes on a Settlement?
Income tax covers money earned for work, so depending on how your settlement is categorized, you may owe taxes on a portion of the award. For example, money received for lost time at work and future earnings is considered income and taxable by the government. Compensation for your physical or intangible losses, such as pain, suffering, and stress related to the incident, are not viewed as taxable income by the IRS.
Here is a list of what compensation the government considers taxable income in all types of legal matters:
- Interest earned on monetary awards
- Payments for lost wages and profits
- Damages for patent or copyright infringement
- Compensation for breach of contract
- Money received for settlement of pension rights
- Punitive damages
The IRS's tax exemptions are varied and difficult to navigate without someone who is accustomed to tax codes, such as an accountant or tax attorney. Ensure your settlement award is itemized to show what the compensation covers to determine what is taxable and exempt.
What Isn’t Taxable in a Personal Injury Award
In short, personal injury settlements are not taxable if they are related to observable physical harm. Section 26 of the U.S. Code establishes what compensation the federal government will tax.
However, if the resulting psychological or emotional distress due to the claim (such as a breach of contract that ruined your business) made you sick, you may need to pay taxes on that amount. The exception to this rule is if physical injury caused your emotional distress. So a personal injury case would more likely yield tax-free compensation for the effects of stress than a case involving the emotional stress of dealing with a defamation case or copyright infringement.
However, some factors can reduce your tax liability, such as how much you already paid for medical expenses for emotional distress not already deducted. Also, medical expenses for emotional distress that were already deducted, but provided no tax benefit, are tax-exempt.
Proper Planning Can Impact Whether You Have to Pay Taxes on a Settlement
With various damages included in a car accident claim, for example, an attorney can negotiate for a higher percentage of a car accident settlement to go towards tax-exempt conditions rather than taxable ones. Your attorney should negotiate your settlement to reflect the distribution of compensation rather than a lump sum for the IRS to interpret. Internal Revenue Code (IRC) Section 61 states that all income is taxable “unless a specific exception exists from whatever source derived unless exempted by another section of the code.” Gross income, as defined by the IRS, includes all income you receive in the form of money, goods, property, and services that are not exempt from tax. When it comes to taxable settlements or court verdicts, it means any amount awarded through these legal processes that don't qualify for tax exemptions forms part of your gross income.
A little planning and preparation go a long way regarding how exposed your settlement is to taxation. Your tax burden is subjective, even if clearly outlined in your settlement, which is why your attorney must act diligently to define each portion of your settlement to avoid an auditor's subjective review, exposing you to unexpected taxes and penalties.
Wiggle room can affect your tax liability greatly, especially when trying to establish if sickness or further injury was due to the circumstances of the claim or for reasons not supported by your claim injury. For example, a medical condition made worse by the events of the accident, such as a herniated disc being exacerbated by a slip and fall, will yield different results than a worsening medical condition that is not directly related to the injury or illness.
Your attorney will be able to help you support this information in your claim, and you can present it to the IRS in the event of a query or audit. The IRS will consider the payer's intent regarding what will be considered taxable and non-taxable in a settlement.
How are Attorney Fees Handled by the IRS?
It might surprise people getting a settlement that they are responsible for taxation on the gross settlement amount, not just what the claimant receives. Most personal injury attorneys work on contingency fees, meaning a percentage of the settlement will pay the attorney for their services in recovering compensation.
If you agreed to pay 30 percent to your attorney out of a $120,000 settlement, they would receive $36,000, but you might need to pay taxes on the full $120,000.
Are Legal Fees Deductible in Lawsuit Settlements?
Generally, you cannot deduct legal fees related to a personal physical injury or sickness lawsuit settlement from your taxes - these settlements are typically not considered taxable income. However, there are exceptions.
Legal fees relating to claims that generate taxable income are often deductible. For example, if you receive a settlement for a discrimination lawsuit or breach of contract case (which are usually considered taxable), the portion of the settlement as legal fees paid to your attorney may be deductible. This would offset some of your tax liability incurred due to the taxable part of your settlement.
However, with changes brought about by the Tax Cuts and Jobs Act in 2017, such deductions have been eliminated for most miscellaneous itemized deductions through 2025 for individuals. Only businesses can continue claiming these deductions.
In contingent-fee arrangements where lawyers' payment is based on winning the case and securing a percentage of awarded compensation — it's essential to understand who technically "receives" this money first according to IRS rules: if viewed as being received directly by plaintiffs before then being transferred to attorneys — this could potentially create additional tax obligations for plaintiffs even though they never actually pocketed those funds.
Therefore, understanding how legal fee deduction works regarding different types of lawsuits is crucial both during negotiation phases determining potential after-tax value of proposed settlements; and post-award while filing taxes ensuring accurate declaration minimizing risk for audits or penalties.
Given these intricacies around laws governing taxation – particularly variations state-by-state– it's always advisable to consult with your personal injury attorney about the correct interpretation and application pertaining to your specific case, maximizing legal deductions and optimizing after-tax value of received settlements.
The IRS Has the Final Say
The IRS can review the language of your settlement and what you agreed to, and it might not hold water regarding what the IRS determines as taxable. Your attorney can clarify the information in your settlement paperwork, but the IRS ultimately makes the decision. Before you sign a settlement, consider and weigh tax liability, or the damages you fought long and hard for might take a significant tax hit and fail to cover your losses.
What Makes Tax Considerations Important?
A lawsuit is a long and often stressful process that you may start with a readiness to fight, but as you progress, you might only hope for a relatively fair resolution. Whether preparing for a jury trial or pursuing repeated negotiations with opposing counsel, you are likely dealing with other challenges that complicate the process.
Whether recovering from physical injuries, sickness, libel, defamation, or any other claim, your mind might focus more on survival and getting through the day. Paying medical bills, supporting your family, and keeping current with expenses is your priority. What happens with tax liability and how the IRS will assess your settlement may rightly not be on your radar.
What you owe in taxes poses a serious threat to what you keep from your settlement agreement once the documents are signed and your lawyers get paid. Without carefully considering what your settlement means for tax liability, you could be saddled with more unnecessary problems.
Discussing your tax consequences with your attorney will allow you to avoid unforeseen liability and hardship. Your settlement money is supposed to help you rebuild your life, not cause more anxiety and stress on top of what you have already experienced. Your attorney will understand how to approach your settlement based on experience, tax laws, and other resources that might be difficult for a typical layperson to interpret.
Contact a Personal Injury Lawyer for More Information About Whether You Have to Pay Taxes on a Settlement
If you are considering a lawsuit due to personal injury damages, you need to contact a personal injury lawyer who will fight for you and your recovery. A skilled lawyer can help you with your claim and guide your decisions, especially concerning expenses, whether your lawsuit settlement is taxable, and how to protect your rights. A lawsuit can cause confusion and stress, but a dedicated personal injury attorney can protect and inform you every step of the way.