Are Lawsuit Settlements Taxable?
Many people look at the end of a lawsuit as a relief, especially if it involves a settlement. While it’s definitely a good thing to rejoice when a financial settlement is granted, it also comes with questions about whether an individual is required to pay taxes on the money they are awarded. I’m often asked this question and the answer, as always when it comes to tax issues, is — it depends. Many people assume settlements are not taxable, but the truth is not quite that clear cut. Whether or not a settlement is taxable depends on the nature of the money awarded.
According to the Internal Revenue Service (IRS), the general rule regarding taxability of lawsuit settlements is Internal Revenue Code (IRC) Section 61. This section states all income is taxable unless exempted by another section of the code. IRC Section 104 provides an exclusion from taxable income with respect to lawsuits, settlements and awards. However, the facts and circumstances surrounding each settlement payment must be considered to determine the purpose for which the money was received because not all amounts received from a settlement are exempt from taxes. The key question to ask is: “What was the settlement (and its corresponding payments) intended to replace?”
Let’s look at which lawsuit settlements are taxable and which are not.
Non-taxable Settlement
Generally, individuals do not have to pay tax on settlements that result from personal physical injuries or sickness. For example, a settlement for medical bills, pain and suffering that resulted from a car accident. According to the IRS, if you did not take an itemized deduction for medical expenses related to the injury in prior years, your settlement is not taxable. You also do not need to pay taxes on the settlement if it is compensation for damaged or destroyed property if the settlement does not exceed your basis in the property.
Other settlements that are generally not taxable include workers’ compensation benefits received for workplace injuries or illnesses, as well as loss of consortium. These are damages awarded to a spouse or family member for the loss of companionship due to a physical injury.
Taxable Settlements
Generally, lawsuit settlements that are taxable — either partially or in whole — are emotional distress or mental anguish (when not originating from a physical injury) and lost wages or income (since regular wages are subject to employment taxes and withholding). Settlements that always incur tax are punitive damages (even from a personal injury case), interest on settlement amounts, and non-injury business or contract claims. Additionally, settlements from a defamation or professional malpractice case (including libel, slander, or legal, tax or financial malpractice) are generally fully taxable.
Additionally, if your attorney’s fees come out of your lawsuit settlement, you may still owe tax on the entire amount. This is generally true unless the case falls under certain employment or whistleblower protections. Structuring your settlements over time may help reduce your tax liability. An experienced tax attorney can help determine the best way to determine if that’s possible and how to set it up. Also keep in mind that state tax liability on lawsuit settlements is generally the same as it is for the IRS.
Lawsuit settlements are complex and the tax implications vary by the situation. If you are in the midst of a lawsuit or expecting a settlement, the best thing you can do is work with an experienced tax attorney who can help you navigate the situation and prepare you for the taxes you may face.
Allison Soares is a partner and tax attorney at Vanst Law LLP. It doesn’t matter the issue: audits, collections, appeals, international disclosures, grumpy people— Allison enjoys fixing problems. In addition to her legal work, she has worked in accounting and utilizes that knowledge to her advantage while handling cases involving EDD audits from San Francisco to San Diego.
