Are Lawsuit Settlements Taxable?

Are Lawsuit Settlements Taxable?

Generally, lawsuit settlements are not taxable, at least for the most part. Punitive damages are the primary exception to this rule. Compensatory damages are not taxable because, well, they’re compensation for economic or noneconomic losses. The IRS usually taxes income, but not assets or compensation.

This rule usually applies in civil claims, workers’ compensation claims, and most other injury claims. So, even if the court awards a large sum of money or the case settles for a significant amount, since a lawsuit settlement is not taxable, victims can properly plan their futures.

That being said, some state revenue departments have different rules. Therefore, an attorney should be aware of the tax laws in your state and prepare settlement agreements accordingly.

How Much Tax Do I Pay on a Lawsuit Settlement?

The formal audit rate has declined significantly in recent years, to a paltry 0.25 percent. But the informal audit rate (the dreaded “Dear Taxpayer” letter) remains high. Fortunately, most lawsuits are tax-exempt under Section 104, making your return audit-proof in this area. These exemptions include:

  • Personal injury judgment or settlement money, and
  • Workers’ compensation benefits.

VA disability rules are a bit more complex. Generally, these benefits are tax exempt. Moreover, disabled and retired veterans may be eligible for some additional tax benefits.

Can The IRS Claim Any Part of My Settlement?

All these exemptions apply to cash payments. Medical benefits might be taxable. Assume Bill is hurt at work. His settlement includes $10,000 cash benefits and a $10,000 medical bill payment. The $10k medical bill payment may be part of his gross income. Once again, it’s complicated, and the rules vary in different situations. Your lawyer can determine the tax impact, if any, in your case. 

The rules regarding noneconomic damages, such as pain and suffering, are complex as well. Usually, the IRS doesn’t tax this money, if the funds are directly related to a physical injury or illness. 

Assume Margaret’s car crash settlement includes an unspecified $50,000 award for emotional distress. If the $50k is compensation for accident shock, it could be taxable. If the $50k is compensation related to Margaret’s car crash injuries, that money probably isn’t taxable.

To avoid this potential problem, an attorney should always include specific language in the settlement documents.

What About Punitive Damages?

Economic and noneconomic damages are generally non-taxable because, according to taxing authorities, this money is compensation for a loss. 

Injury compensation is almost like a loan repayment. If Sarah borrows $10,000 from Michael and she repays it, Micahel doesn’t pay taxes on the $10k. Likewise, if Sarah causes a car crash that injured Michael and she (or rather her insurance company) paid him $10k, that money isn’t taxable.

This theory does not apply to punitive damages. Courts award punitive damages to punish wrongful conduct and deter future misconduct, not to compensate victims. Since punitive damages are not compensatory in nature, the IRS taxes them.

Sometimes, there’s a fine line between noneconomic damages and punitive damages. Once again, the settlement or judgment should include distinct language that specifically describes each payment category.

Should I Worry About Taxes and Personal Injury Settlements?

Frequently, the stress over potential tax liability is worse than the stress the injury caused. Try to remember a couple of things. First, even if the entire personal injury settlement is taxable (which it isn’t), the pocketed settlement money far exceeds the tax payment. Second, count on your lawyer to sort out these issues. An experienced lawyer has dealt with this same situation many times before.