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As you prepare to accept a personal injury settlement, you may focus on the expenses it pays, and owing taxes on it might not have crossed your mind. However, the government usually gets a portion of any money you receive through a paycheck, winnings or other means, such as compensation awarded in a legal action. Since these cases can result in large payments, it is essential to know if lawsuit settlements are taxable or not.

Here’s something else to remember: The burden of proof for your payment’s tax treatment lies with you, the taxpayer. Learning the laws regarding settlement taxation keeps you from making costly tax errors.

Are Lawsuit Settlements Taxable?

Ask your lawyer if your lawsuit settlement is taxable.

In short, lawsuit settlements are taxable, but it depends on what they cover. The IRS wants to know what expenses or conditions the compensation intends to replace. You may hear your lawyer refer to this concept as the “origin of the claim” test.

What Your Proceeds May Cover

A settlement may cover several types of expenses, including:

  • Medical bills
  • Prescription drugs
  • Pain and suffering
  • Lost wages

It may also cover attorney and court fees and other associated costs.

The General Rule on Settlement Taxation

The Internal Revenue Service’s general rule is that lawsuit settlements are taxable in most cases. The blanket statement as part of IRC Code 61 is: “All income is taxable from whatever source derived unless exempted by another section of the code.”

It’s important to note that the IRS treats settlement awards the same whether they result from winning a case at trial or settling out of court.

IRC Code 104 includes exceptions for personal injury cases. Your settlement is probably not taxable if you experienced physical injuries (sometimes called observable bodily harm) or illness.

Your settlement is taxable if it is for a nonphysical event, such as:

  • Discrimination
  • Wrongful termination
  • Defamation

Lost wages and back pay are taxable unless they resulted from a physical injury. Interest on the settlement is also taxable. Punitive damages are usually taxable, even if they’re part of a personal injury case.

What Are Examples of Nontaxable Proceeds?

“Personal injury” is an umbrella term that includes different types of conditions suffered from different circumstances, and the actual basis of your claim usually determines whether your claim is taxable or not.

Physical Injuries or Illnesses

Say, for example, you have suffered a slip-and-fall accident in which you sustained broken bones. Another case may be becoming critically ill due to a faulty carbon monoxide detector. Your lawsuit settlement is probably not taxable in this case.

The IRS typically won’t disturb the allocation if everything is consistent with the basis of the settled claim. There is an exception, however, if you took an itemized deduction for medical costs directly related to the injury or illness.

Emotional or Mental Distress

Your settlement may include compensation for emotional or mental distress that you can attribute to the physical injury or sickness for which you’re filing the claim. Suppose you develop a chronic psychological condition, such as anxiety or depression, after sustaining serious injuries in a car accident. In that case, your compensation is generally nontaxable.

Lost Wages

Settlement payments can include lost wages due to a personal injury or illness. Say you suffer a traumatic brain injury from a factory workplace accident, and your symptoms prevent you from performing your job during the initial recovery period. The IRS considers such awards as compensation and excludes these wages from your gross income, so they are also nontaxable.

Bear in mind, however, that lost wages are not taxed only if an injury or illness is the basis for your claim. For example, if a breach of contract caused a stress-induced emotional condition that prevented you from working, the breach is the basis for the lawsuit, and the IRS would tax your lost pay as ordinary income.

Wrongful Death

Merriam-Webster defines a wrongful death as “A death caused by the negligent, willful, or wrongful act, neglect, omission, or default of another.” An example could include a loved one lost in a vehicle accident involving a truck driver who operates his or her 18-wheeler under the influence of a substance, whether it is illegal or not.

The government views income from wrongful death settlements through the same lens as personal injury proceeds. Therefore, an award from a loved one’s wrongful death settlement is nontaxable.

What Are Examples of Taxable Settlement Proceeds?

If the basis of your claim falls outside of a physical injury and the associated conditions caused by that injury, it is safe to assume that your lawsuit settlement will be taxable.

Previously Deducted Medical Expenses

Suppose you received a cancer diagnosis last year, received treatment and already paid related medical bills. You then deducted the expenses from your taxes. After you filed the return, you learned that the cancer resulted from toxic substances in your workplace environment, and you filed a lawsuit. In that case, the settlements for those expenses are taxable; otherwise, you’d get the same tax benefit twice.

Mental or Emotional Distress Unrelated to a Physical Injury

The proceeds from a lawsuit settlement are taxable if they compensate you for emotional or mental distress that isn’t related to a physical injury. This type of distress is defined by the inability to manage it like a reasonable person could and often requires some form of treatment.

Some examples might include the humiliation that comes after defamation or the shock and grief you might suffer after a wrongful termination. Anti-retaliation, discrimination and harassment, sexual or otherwise, can trigger emotional distress as well.

Lost Wages Unrelated to a Physical Injury

Lost wages awarded in an employment-related lawsuit are taxable if they’re not related to a physical work injury or illness. Anti-retaliation and discrimination settlements are examples of this category. Lost wages can include:

  • Back pay for work you have completed but haven’t received payment
  • Front pay for work you would have completed during the period of the lawsuit if reinstatement or a more appropriate job with the company is not possible
  • Severance pay for termination

These lost wage payments are also subject to Medicare and Social Security taxes, just like a standard paycheck.

Punitive Damages

The court awards punitive damages to punish the defendant for doing something malicious, reckless or grossly negligent, such as injuring a child while speeding in a school zone. Generally, these damages received in lawsuit settlements are taxable.

You must report punitive damages as income, even if they are part of a physical injury settlement. The IRS considers this compensation as “other income” on Form 1040, Schedule 1.

There is an exception: IRC Section 104 excludes punitive damages from taxation when they’re part of a wrongful death settlement.

Interest Paid on Settlements

Sometimes, a settlement isn’t paid right away. This may happen if the defendant files an appeal after a jury trial; they don’t have to pay the settlement until the court makes a final judgment. If this is the case, interest will begin to accrue on the settlement amount from the date of the verdict, and the interest may be subject to taxation.

What About Complex Settlements?

Are complex settlements taxable?

Settlements are often multifaceted and contain several different types of awards. Part of your proceeds may be subject to taxation, while others might not.

Dealing With the Different Parts of a Settlement

Say, for example, you are involved in a defamation lawsuit. While the proceeds from those types of cases are usually taxable, the emotional distress of defamation led to stomach pain and persistent headaches. You incurred medical expenses while getting treatment. Do you have to pay taxes on the entire lawsuit settlement?

Another example is getting in an accident that worsens an existing medical condition, such as a fall that aggravates your chronic back pain. Since the IRS considers the payer’s purpose and reasons for awarding money, will these expenses relate to your proceeds?

Answering questions like these is essential to preparing a complete and correct tax return. A lawyer familiar with lawsuit settlement taxes can advise you on how to proceed.

How Can a Personal Injury Lawyer Help?

Tax laws are notoriously complex; sorting them out can be challenging. Our personal injury lawyers have experience with settlement allocation as it relates to your tax responsibility.

Itemizing Your Settlement

Our attorneys are familiar with the tax codes involved in personal injury cases. We can help you sort through the elements of your award that are subject to taxation and what are not.

Itemizing your settlement helps you at tax time. A lawyer can define the taxable and nontaxable categories of the settlement before you file rather than leaving an auditor to subjectively determine what should be taxed after the fact.

Negotiating for Higher Tax-Exempt Percentages

Rather than getting your proceeds in a lump sum, distributing your compensation into categories can lessen your tax burden. If your settlement will contain nontaxable and taxable awards, our legal team can work to negotiate for higher amounts of your settlement to go toward nontaxable items.

Spreading Payments Into Multiple Years

The more income you make annually, the higher your tax bracket is. This tax rule is valid whether you earn more money at your job or receive it another way, such as through a settlement.

If you receive a large sum all at once, it can put you in a different tax bracket and significantly affect the amount of taxes you owe. However, your lawyer may be able to negotiate to spread your settlement payments over time.

Gradually receiving the funds may help you reduce your tax obligations. It may also benefit you to receive ongoing payments if you expect to have medical bills or other costs to consider in the future. Additionally, there may be a great temptation to spend a large sum too quickly, and spreading out payments can help lead to better financial responsibility.

Understanding Legal Fee Deduction

Lawyers working on contingency fees generally receive a percentage of a settlement. If the IRS perceives you as “receiving” the lump sum of the settlement first, you may owe taxes on the entire amount, even if the law firm received its portion beforehand.

Legal fees are tax-deductible in some cases, but the laws surrounding them can be complex. Only fees incurred in certain types of lawsuits qualify as nontaxable, such as claims due to civil rights, employment and some whistleblower cases. Our lawyers will apply the knowledge and skills necessary to optimize the legal fee deduction process.

Your lawyer will work to help you increase the after-tax value of your settlement, helping your proceeds go as far as possible to cover expenses and compensate you for your losses.

Why Is It So Important To Consider Taxes on a Lawsuit?

Daily life can present many challenges when you or a loved one are involved with a claim. Determining whether your lawsuit settlement is taxable may be on the back burner. You may be facing circumstances such as:

  • Keeping up with hospital bills
  • Going to medical appointments and therapy
  • Financially supporting yourself and your family
  • Navigating your new “normal”

When you have pressing matters like these, tax considerations can be far from your mind. However, when tax season inevitably rolls around, you want to avoid unpleasant surprises that add to your stress and anxiety.

Your tax burden can significantly affect how much of your settlement you get to use. However, your attorney can discuss the tax implications of your case with you from the beginning. Our lawyers are familiar with the tax laws surrounding personal injury cases, and they know how to optimize your settlement.

Sargon Law Group Can Help You Determine Whether Your Lawsuit Settlement Is Taxable

Preparing for a claim takes time, effort and planning. Whether your case settles out of court or goes to trial, these factors are true. Tax implications are one of the many critical components of your claim.

The professionals at Sargon Law Group can advise you on how taxes may affect your case. You can also find out if a lawsuit settlement is taxable in your circumstances. We are available to help you whether you are in Phoenix, Glendale, Peoria or other Maricopa County cities. Contact us today to schedule a free consultation and learn how we help our clients get the compensation they deserve.