More often than not, a case gets resolved when two parties reach a settlement, where the defendant pays the plaintiff an agreed-upon amount in compensation. If you are the plaintiff (the person filing a claim) in this scenario, it might be tempting once a settlement is reached to collect the proceeds and not look back.
However, depending on the nature of your case, receiving a settlement payment could be subject to taxation. To prevent any surprises come tax time, there are some general tax guidelines to keep in mind that could affect your settlement payout. These rules are a starting point and it may be best to speak with a tax professional if you need guidance on how a settlement is taxable.
Determining How Legal Settlements Are Taxed
Every case is unique, but generally speaking, settlements are taxed by the U.S. Internal Revenue Service, or IRS, according to the reason for the claim which gave rise to the payment—also known as the “origin of the claim”. The cause for a claim can depend heavily on the specific facts and circumstances of the case.
For instance, settlement payments for employment-related claims involving unpaid wages are typically taxable by the IRS as ordinary income. In this way, the IRS considers you receiving those settlement proceeds as, more or less, a form of you receiving those wages.
On the other hand, if your house was damaged by a negligent contracting company and you reached a settlement with them, it’s likely that the payment you’d receive would be considered repayment for destroyed capital—as opposed to ordinary income—and therefore, not taxable.
Settlement payments are often considered taxable income by the IRS, but perhaps the biggest exception to that rule comes into play with settlements to compensate for personal injuries.
Is A Personal Injury Settlement Taxable?
If you sue after being physically injured, such as in a car accident or a slip and fall, the compensation (punitive damages not included) that you’d receive after reaching a settlement would be considered non-taxable by the IRS.
This rule may seem odd, because it’s common for settlement proceeds in personal injury cases to include reimbursement for underlying losses that are otherwise usually taxable when they are claims, like lost wages or emotional distress.
Regardless, as long as the origin of a claim is based on a personal physical injury or a physical sickness, there is a specific section of the tax code (section 104) to keep settlement compensation for that injury or sickness from being taxed.
You may be wondering what is considered a “physical” injury when it comes to determining whether you will have a tax-free settlement. The IRS has not provided a clear definition, but has generally stated that injuries must show “observable bodily harm,” (such as cuts or bruises) in order to be considered “physical”.
In cases of sexual harassment, courts have disagreed over whether elements of a claim such as inappropriate touching can amount to a physical injury that is covered by this tax rule.
The U.S. Tax Court has allowed for at least partial tax relief in some employment lawsuit settlements where an employee became physically sick, or where their previous illness became worse, after becoming a victim of their employer’s harassment.
If you have been injured and are unsure of how your claim is taxable, it might be best to speak with an attorney about the details of your case.
Taxes On Emotional Distress Settlements
It’s important to keep in mind that the IRS’s standard for visible harm in personal injury suits draws a line between taxation for physical injury claims and claims for emotional anguish, or distress. As opposed to claims originating from a physical injury, settlement recoveries for emotional distress claims usually are taxed.
This rule also highlights the difference between a plaintiff showing physical signs of emotional distress (such as headaches, insomnia, and nausea) and physical injuries or sickness. Even if emotional distress has the effect of bringing on physical symptoms, the IRS generally treats the settlement proceeds from the claim for that emotional anguish as taxable income.
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Other Factors That Might Affect Settlement Taxes
Aside from emotional distress, other lawsuit factors which are commonly involved in settlements and usually taxable include:
- punitive damages
- settlement proceeds for non-injury claims
- pre- and post-judgment interest
- attorney fees, when the underlying claim is taxable
- settlement proceeds for employment-related claims (unless the origin of the claim is non-taxable, as with a claim for lost wages in connection with a personal physical injury or sickness)
In a personal injury case, it is common for a defendant to pay an agreed-upon amount in a settlement to compensate the plaintiff for their damages, or losses. In some rare cases, punitive damages may be awarded as well.
Punitive damages usually serve the purpose of punishing the defendant, rather than compensating the victim, and generally speaking, they are treated as taxable.
Settlements For Non-Injury Claims
Non-injury claims, including breach of contract claims, are generally taxable as long as they are the basis (the origin) of a claim and the resulting settlement payout. For example, even if a breach of contract causes you to be physically injured or develop a physical sickness, typically the proceeds from the arising settlement would be taxable.
Many states require interest to be added to a verdict for the amount of time payment is pending. The interest amount that is tacked on is generally taxable by the IRS. For example, if a plaintiff is successful in court and is awarded a verdict, but the defendant appeals, payment on the verdict may remain pending for years.
When the defendant does begin to pay the verdict, there may be interest added from the time the verdict was awarded to the plaintiff but left unpaid through appeals. Typically, the plaintiff would be taxed for the amount of interest added in that time period.
Attorney Fees Paid From A Settlement
It is fairly common for attorneys to work on what is called a “contingency fee basis”, especially in personal injury cases. This usually means that the lawyer is paid a percentage for their services, which is deducted and paid out from either a resulting settlement or from a court verdict. A contingency fee that is paid from a settlement should be reported in taxes as part of the total payout if the underlying settlement is taxable.
For example, say you sue your teacher for intentional infliction of emotional distress and reach a taxable settlement with them for $100,000. Your attorney’s contingency fee amounted to 40 percent, or $40,000.
It might be easy to assume that only $60,000 should be recorded as income, but that may not be the case. For taxable settlements including attorney fees, the amount will likely be treated as though you have received the full $100,000 in income.
Even if the defendant directly pays the attorney fee, you should include the attorney fee as though it is part of your taxable income from the settlement payout. Fortunately, you may be able to claim your attorney fee as a deduction from your taxes.
Depending on the circumstances, claims that involve the plaintiff’s trade or business can allow for what is called an “above the line” deduction that considers the legal fees a business expense. Some whistleblower claims or claims that are brought against employers can also offer an “above the line” deduction for your legal fees.
You may be wondering what tax consequences are in place for settlement payouts that are not taxable. If the origin of your claim gives rise to a tax-free settlement (say from a personal physical injury, such as a dog bite or a car accident) then the attorney fee is generally tax-free as well.
If you have received a settlement payment and are unsure how to report attorney fees, speaking with an experienced lawyer about the circumstances of your case could help.
Medical Expenses Are Generally Tax-Free
Regardless of the origin of your claim, expenses for medical treatment are generally non-taxable. Even for a claim of emotional distress, where settlement proceeds are typically considered taxable, you are likely not going to be taxed on the amount you paid for medical expenses.
Medical expenses can include costs paid to traditional as well as non-traditional care professionals, such as:
- physical therapists
An important exception to this rule is that settlement compensation for medical expenses could become taxable if you used those expenses to get a deduction in a previous year and doing so produced a tax benefit to you (it reduced your taxes).
This means that if you secured a tax benefit for deducting medical expenses in a previous year, then the consequence of receiving a settlement payment to reimburse you for those medical expenses is that the amount is treated as taxable.
On the other hand, if you previously reported medical expenses to get a deduction and it did not result in a tax benefit, then you could be saved from being taxed on that amount of medical expenses in your settlement payout.
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How A Settlement Agreement Affects Taxable Settlements
It’s important to remember that every case, and settlement, is unique and these tax rules involve many exceptions and conditions. Case facts and circumstances can play a large role in finding out what financial elements of a settlement are taxable.
With so much variation, it can benefit both a plaintiff and a defendant greatly to be thorough in their settlement agreement when it comes to determining what “allocations” or categories of settlement compensation, will be paid to the plaintiff in the settlement.
For this reason, more detailed settlement agreements can be beneficial at tax time because they can include a layout of written details about what types of compensation the defendant will pay for certain losses, or damages.
For example, a plaintiff and a defendant who reach a settlement for personal injury claim can use their settlement agreement to determine what amount the defendant will pay to reimburse the plaintiff for their lost wages, how much will be paid for the plaintiff’s emotional distress, how much for the plaintiff’s physical injury, and so on.
Parties to a lawsuit can also benefit from a settlement agreement that includes their agreed-upon tax treatment for each allocation. This gives the parties the chance to advise the IRS on what tax consequences they would prefer to have after reaching the settlement.
Although settlement agreements are not binding in law or on the IRS’s action, they can be considered for tax treatment by the IRS when the allocations match the origin of the claim.
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If you have questions about the tax consequences of reaching a legal settlement, you are not alone. Our results-driven attorneys stand ready to advocate for you through the settlement process, and in trials, with experience in a diverse range of case types.
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