Most money awarded due to a lawsuit claim will be subject to taxes. The IRS is a governing
body that exists to collect taxes, and collecting taxes is what they do best! To ensure you are
following the tax codes and laws correctly, we suggest speaking with a professional accountant
as soon as possible, especially if you stand to collect a large, 6 or 7 figure settlement.
Settlement money and damages collected from a lawsuit are considered income, which means
the IRS will generally tax that money. However, personal injury settlements are an exception
(most notably: car accident settlements and slip and fall settlements are nontaxable).
Lawsuit settlements and damages can be arranged into two groups taxable and nontaxable. There
are exceptions to every rule, and each lawsuit claim is unique. Again, we suggest seeking advice
from an accountant where possible.
Remember, according to the IRS, gross income includes “all income from whatever source
derived.” This means almost every penny earned in a settlement is taxable, except personal
injury and physical injury 26 USC § 61(a).
NONTAXABLE LEGAL SETTLEMENTS
Physical Injury Awards
Physical injury awards are usually nontaxable. The IRS does not tax settlement awards from
personal injury lawsuits if these cases demonstrate “observable bodily harm.” So, if the injuries
are visible, the IRS considers compensation money awarded because of those injuries tax-free.
Do not include these settlements in the income section of your tax forms.
Car Accident Injury Settlements
Car accident injury settlements are almost always nontaxable. Any major claims a car accident
lawyer settles will almost always be nontaxable. Cases handled by personal injury lawyers are an
exception to any settlement awards that consider income. Remember, those fees can be taxed if a
lawyer chooses to work for contingency fees (where the attorney collects fees after winning a
case). However, that is not the case with car accident cases or other personal injury cases like
slip and fall or workers’ compensation. Those contingency fees will not be taxed!
Do not include these settlements in the income section of your tax forms unless you have also
incurred medical expense reimbursement from the previous year.
Medical expenses are nontaxable if no deduction was taken previously. Medical visits for emotional distress or physical injury are nontaxable if you did not take an itemized deduction for
these expenses in prior years. However, if you settle and are reimbursed for medical expenses
after taking a deduction in previous years, you will be required to pay a tax that year; this is a
specific IRS rule called the “tax benefit rule.” Include these reimbursements in the “Other
Income” section on line 21 of the 1040 Form.
Emotional Distress Awards
Emotional distress awards are nontaxable. Any settlement money received for emotional distress
is nontaxable if the distress or anguish originated from the physical injury or sickness caused by
the accident. However, remember that any medical expenses incurred will be subject to the rule
above, and deductions will be taxable when the settlement is reached. Any emotional distress
that is not caused by any physical injury from the accident will be taxable, so the distinctions
must be made.
TAXABLE LEGAL SETTLEMENTS
Punitive Damages and Interest
Punitive damages and interest are taxable. This is where things can get somewhat complicated.
Any pre-judgment or post-judgment interest on settlement money is taxable and may influence
taxes on some attorney fees. The same can be said for any punitive damages awarded. We advise
you to speak to a professional accountant as soon as possible.
Lost wages are taxable. Lost wages are considered taxable because wages are income that would
have been taxed if they were received without interruption. Not only will income tax be added,
but these wages are also subject to Social Security taxes and Medicare taxes.
What to Know When Filing Taxes
According to the IRS, determining how to file for taxes when you receive compensation takes
the careful assessment. You need to identify how the settlement payment was processed to file
correctly. You can do so by reviewing court-related documents or other relevant documentation
of the settlement to figure out this information. It’s crucial whenever your personal injury case
has been settled, you keep track of all documents concerning the compensation payment and
make sure it doesn’t get lost.
The information needed about settlement payment:
▪ Was the payment placed as income, in whole or in part?
▪ Was the payment placed as wages, in whole or in part?
▪ Do you have the proper reporting requirement forms, 1099 or W-2?▪ Did you receive settlement check(s) or scheduled payments?
▪ What was the amount of legal fees paid?
It’s also important to keep in mind that if you have two claims against a defendant and settle for
both, indicate the amount for each. For example, if one claim is personal injury-related and the
other is a non-personal injury claim, one settlement is excluded from taxation while the other is
not. If you have no documentation about the amounts for each claim, the IRS will challenge the
non-taxability of the settlement. It is crucial to identify which settlement amount is personal
injury-related, mainly because that settlement will often be a more significant amount than the
non-personal injury claim settlement. When you settle your case with your attorney, you can
have the documentation specific to outline the different compensation amounts.
Should you have any questions or concerns, please do not hesitate to contact Nooney, Roberts,
Hewett & Nowicki at (904) 398-1922 today!