The compensation you’ll receive from a lawsuit settlement is taxable unless the lawsuit concerns personal injury. So, more often than not, the IRS will treat a portion or the entire settlement sum as income and require you to pay the appropriate tax.
This guide will help you understand your tax obligations in 2023 and assist you in maximizing any lawsuit settlement proceeds and avoiding paying unnecessary taxes.
Table of Contents
Understanding The Difference Between a Lawsuit Settlement And Court Awards
Before we go deeper into the tax implications of lawsuit settlements, let’s first look at the differences between a court award and a lawsuit settlement.
A court award is a decision a judge reaches after considering all evidence during a trial. This decision can include financial compensation a defendant must pay to a plaintiff as well as penalties and legal fees.
A lawsuit settlement eliminates the need for a trial as both parties agree on the amount sufficient to cover the damages the plaintiff suffered. Consequently, a settlement will enable you to resolve the matter faster and get compensation for the hardship you’ve experienced.
In the eyes of the IRS, there’s no difference between court awards and lawsuit settlements because, in either case, the amount a plaintiff receives is taxable.
A Quick Overview of IRS Lawsuit Settlement Regulations
Section 61 of the IRC states that ‘all income is taxable from whatever source derived unless exempted by another section of IRC.’
This section of the Internal Revenue Code stipulates that all additional income a taxpayer earns during a year must be included in the gross income calculation.
However, Section 104 creates an exception to this rule by allowing taxpayers to exclude personal injury compensation from their gross income amount.
Subsections of IRC Section 104 further elaborate that punitive damages cannot be exempt from taxation, even in physical injury lawsuit settlements.
Publication 4345 provides further guidance to taxpayers who receive settlement proceeds on how this type of income is taxed and the circumstances under which settlement compensation is nontaxable.
Understanding the implications of IRC Section 61 and Section 104 before filing a lawsuit will help you avoid unpleasant surprises after you settle a lawsuit.
Nontaxable Lawsuit Settlement Compensation
Not all proceeds from lawsuit settlements affect your gross and taxable income. So, whether or not you’ll have to pay more federal taxes than usual depends on the type of lawsuit you file.
Settlement compensation from the following types of lawsuits usually isn’t taxable:
- Emotional distress resulting from a physical injury: Settlement proceeds that include damages for the emotional pain a plaintiff suffered due to a bodily injury are nontaxable.
- Physical injury lawsuit settlements: Wrongful death or car accident lawsuit that end in a settlement aren’t taxed. The compensation often includes costs of medical treatment and lost wages reparation.
- Physical sickness: Plaintiffs who were exposed to chemical substances or endangered their health in some other way don’t have to pay taxes for the lawsuit settlement proceeds they receive.
- Medical expenses: Lawsuit settlements that include compensations for the costs of medical treatment are nontaxable only if the plaintiff hasn’t already claimed these expenses on their tax return.
It’s important to note that lawsuit settlements often include taxable and nontaxable compensation, so you may have to pay taxes on settlement proceeds even if you can clearly demonstrate ‘observable bodily harm.’
Taxable Lawsuit Settlement Income
The vast majority of lawsuit settlement proceeds are taxable. Hence, if you file these types of lawsuits, you’ll have to include any compensation you receive in your gross annual income.
- Lost Wages: The total compensation amount of a lawsuit settlement involving lost wages is taxable. Moreover, you’ll also be asked to withhold Medicare and Social Security taxes from lost wages damages.
- Non-physical lawsuits: Copyright infringement, libel, wrongful termination, property damage, and all other types of non-physical lawsuit settlements are taxable.
- Emotional distress: You’ll have to pay taxes for the entire settlement amount if you file a lawsuit regarding the emotional pain caused by libel or wrongful termination.
- Settlement interests: Pre and post-judgment interests are subject to federal tax, and you must report them on your tax return.
- Punitive damages: A lawsuit settlement can include punitive damages the defendant must pay as a punishment for their actions. These damages are taxed in both physical and non-physical injury lawsuits.
The amount of federal tax you’ll have to pay depends on the terms of the settlements. You should explore different ways to lessen your tax burden with your attorney before the settlement.
The agreement should outline the compensation payment plan so that the IRS can consider the settlement distribution plan rather than the entire sum.
Don’t forget that the IRS reserves the right to review your lawsuit settlement and decide which portion of the proceeds is taxable.
Reporting Lawsuit Settlement Proceeds to The IRS
Attorneys usually work for a contingency fee that allows them to take a percentage of the settlement amount. So, a portion of your proceeds will go to your attorney after you sign the agreement.
However, you’ll still have to pay taxes for the entire compensation amount. That’s why you can easily end up with only a fraction of the sum you thought you’d get from the lawsuit if you don’t pay attention to how taxes can affect your lawsuit settlement.
These proceeds can push you into a higher tax bracket as they’re treated as regular income for taxation purposes. As a result, you must consider a broad range of factors before agreeing to the terms of a lawsuit settlement.
The forms you must attach to your tax return will depend on the lawsuit type. In case of a physical injury lawsuit settlement, an insurance company should issue Form 1099-MISC you must attach to Form 1040 when filing taxes.
You may receive a Form W2 after settling a lawsuit over lost wages or Form 1099-INT if you’re eligible for judgment interests.
Calculating how much you owe to the IRS after you settle a lawsuit can be complicated, and hiring a professional tax preparer can help you avoid an audit or paying easily avoidable penalties.
Frequently Asked Questions
The purpose of punitive damages is to punish the defendant, which is why the wrongdoer will be responsible for paying the damages and appropriate taxes.
The proceeds of all non-physical injury lawsuit settlements, including defamation lawsuit settlements, are taxable.
The IRS treats lawsuit settlement compensation as income. Hence, the funds you’ll receive after settling a lawsuit are taxed the same as any other source of income you may have.
You may be able to treat a portion of the settlement amount as capital gain if you file a property damage lawsuit.
The Importance of Planning When Settling a Lawsuit
The terms of the settlement agreement will affect how the compensation you receive will be taxed. Sometimes negotiating a payment plan instead of getting the entire sum at once can help you avoid paying higher taxes.
Your attorney should present all implications of a lawsuit settlement and help you understand how much money you’ll have after legal fees and taxes.
Most importantly, you should be aware that all lawsuit settlements are taxable and understand the circumstances under which the proceeds can be exempt from taxation.
That’s why your attorney should assist you in forging a settlement plan and ensure that the amount you’ll take home after taxes is sufficient to repair the damage you suffered.
Author:
Logan is a practicing CPA and founder of Choice Tax Relief and Money Done Right. After spending nearly a decade in the corporate world helping big businesses save money, he launched his blog with the goal of helping everyday Americans earn, save, and invest more money. Learn more about Logan.
