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Are Lawsuit Settlements Taxable?

Find out about the tax implications of receiving a lawsuit settlement and what you can do to protect your money.

After getting involved in a rough accident, you and the offender decided to settle out of court. This means that they take liability for your injuries, and they are willing to compensate for any damages they dealt with you. Now, you signed a settlement release so you can get your settlement money.

But a question popped in your head. Are lawsuit settlements taxable?

This is a common question for any plaintiff who agreed to settle out of the court. The answer to this question is vague and complicated. Settlement taxability differs from case to case. Let’s discuss how lawsuit settlements are taxed and what are the non-taxable and taxable settlements.

How Are Tax Implications Determined For Legal Settlements?

The Internal Revenue Systems or IRS determines if a personal settlement claim is subjected to tax. Generally, the IRS will consider your settlement money as taxable income once it enters your account. But, exceptions exist even in this rule. Personal injury settlements are considered non-taxable by the administering department.

It all boils down to the “origin of the claim.” If the nature of your settlement is for seeking a settlement for lost wages, it is taxable. But if the nature of your settlement is for seeking compensation for the damages sustained by accident, it is non-taxable. But, settlements for non-physical injuries such as mental anguish are taxable by the IRS.

Allocating settlement funds is a good strategy to reduce tax implications. The majority of legal issues cover multiple concerns. For example, a victim could claim that he sustained a physical injury from the car accident, developed a trauma from the damages caused by the event and lost daily earnings because of the accident. The issue for this event revolves around the car accident, but the settlement could cover several facets.

This is why both parties must agree on the tax treatment of the settlement fund. The settlement agreement should discuss in detail how much is allocated for each of the victim’s disputes.

Personal injury settlements also cover the attorney fees. If a plaintiff hires a contingency-fee-basis lawyer, they will not get paid until the victim recovers money from the case. Even if the defendant pays the attorney’s contingency fees, the settlement money will still be subjected to the attorney fee taxes.

If the claim covers physical injury or sickness, there should not be any trouble with the tax treatment. But, if the claim is non-physical sickness or injury, then it is subjected to tax. Later on, we will discuss more on the attorney fees in this article.

In a nutshell, all physical injuries or physical damages settlements are tax-free. But, since emotional distress is not ‘physical,’ it may be subjected to tax depending on the nature of the case. Punitive damages and attorney fees are also subjected to tax treatment.

The best strategy to minimize the settlement tax deduction is to have a settlement agreement between the defendant and the victim. This would help them see which allocated settlement funds will be taxed.

List Of Non-Taxable Settlements

As mentioned above, settlements originating from physical injury are tax-free. Listed below are some of the examples of settlements exempted from tax.

Physical Injury Awards

A personal or physical injury settlement is considered a tax-free settlement. The basis of the IRS in settlement taxability is basically if the victim exhibits physical injuries. As long as there is observable bodily harm, the IRS exempts these settlements of tax.

Emotional Distress Settlements

The Internal Revenue Systems published a document stating that emotional distress settlements are spared from tax if the emotional distress damages originate from a physical injury or physical sickness. But, if an existing physical injury does not cause mental anguish, it will be taxed.

Medical Expenses

The same document states that medical expenses spent on physical sickness or emotional distress are non-taxable if the victim did not take an itemized deduction for these expenses from the previous year. But, if the victim receives the personal injury settlement as reimbursement for previously deducted medical expenses, then it is taxable.

List Of Taxable Settlements

Settlement payments originating from causes other than personal physical injury are subjected to tax.

Punitive Damages

The court awards punitive damages as a punishment for the person liable for the accident. In most cases, these damages are given in extreme cases, usually involving fraud or negligence. This is not meant to compensate the victim. Instead, these damages are meant only as a form of penalty against the violator. In this sense, punitive damages are subjected to a tax deduction.

Non-Injury Claims

As established earlier in this article, claims not originating from physical injuries or physical sickness are subjected to tax payments. Non-injury claims could include claims for property damages, lost wages, or interests. Property damages, lost wages claims, and punitive damages should be listed as ‘Other Income’ of Form 1040. While interests should be classified as ‘Interest Income.’

Case Interest

Most states in the United States require an interest to be added on a pending verdict. The interest increases the longer the verdict is left unpaid. These interests are taxable by the IRS. The defendant will pay the awaiting verdict along with the interests included.

Attorney Fees

The attorney fee is a complicated area in taxable settlements. If an attorney representing you in a case functions on a contingency basis, you must pay taxes as the entire money recovered from the case. Even if the case defendant pays the lawyer’s contingency fee, you are still subjected to tax payment by the total amount of compensation if the nature of the settlement is not physical injury.

For example, a plaintiff settled an amount of $100,000 for emotional distress, and the attorney fee cost you $40,000. You are then left with a $60,000 settlement money. Usually, you would assume that you would only record $60,000 as your income from your settlement. But, the law states that you should declare the total $100,000 as taxable income.

How Are Taxable Settlements Affected By A Settlement Agreement?

To understand how a settlement agreement affects taxable settlements, let us first define the settlement agreement.

Settlement agreements are a legal contract agreed upon by the defendant and the plaintiff. If a victim declares several claims from the accident, it is helpful for both parties to decide which amount would go to the different claims.

For example, a victim could request compensation for mental trauma, physical damages, and lost wages caused by an accident. It is helpful to know which amount would cover each category. A settlement agreement is ideal in this scenario.

A good settlement agreement would include the following information:

  • Details and facts relevant to the case or accident occurred;
    • The amount agreed upon by both parties;
    • The allocation or categories of the settlement fund;
    • How much is going to be allocated in these categories;
    • Personal information of the defendant and the victim relevant to the situation;
    • A statement that both parties agree to the terms and conditions stated in the agreement;
    • Signature of both parties indicating that they fully understand and acknowledge the terms in the contract.

Settlement agreements can also include the agreed tax treatment between both parties. Though the IRS and the court are not mandated to follow the settlement agreement, they can incorporate the decision of both parties on what tax consequences both parties agreed upon.

The court may not add any terms to the agreement and only accept what is included in the document. This is why both parties must specify what they want to go in the settlement agreement. As much as possible, avoid accepting a contract with a lot of ambiguous terms.

An experienced settlement agreement lawyer can help you set your desired terms to get the best outcome with your case. They can go over the other party’s agreement and advise you if the document is detrimental on your end.

How Can Allocation For Damages Save Taxes?

As established in the earlier sections, the best strategy for minimizing tax deductions in your settlement money is to divide the funds in each category of claims.

When a victim receives the settlement money, the IRS will consider this settlement as income. An income settlement is taxable by the IRS. But, if the nature of the settlement originates from observable harm or physical sickness, then the IRS can exempt this settlement from tax consequences.

But, if the settlement received originates from non-physical injury claims, this is subjected to tax deductions. Non-physical injury claims include mental anguish and distress from the situation. But, if the victim developed these mental health damages from the sustained physical injuries, it is not taxable.

Most legal cases have many damages compensable by the law. A car accident can bring severe physical injuries to the victim, and they could develop anxiety disorders because of the event. Wrongful death can bring emotional distress and loss of consortium. Some of these damages are taxable, while some are not.

Allocating settlement for these damages reduces the number of tax consequences from the payment. For example, the total compensation recovered by the victim is $100,000, then they could divide $60,000 for physical injuries and $40,000 from taxable loss of income. An agreement between both parties should be made before the settlement fund could be distributed between the damages.

Before settling for an amount outside the court, both parties should sign a settlement agreement. This document is helpful in making decisions on how both parties would like the settlement money to be treated.

A victim should provide solid evidence to connect the mental health damages from the physical injuries obtained.

Protect Your Settlement Money

Taxes are a perpetually confusing topic to understand. The laws surrounding this matter are complicated because it contains many technicalities that are too hard to understand.

Protect your settlement money by hiring an experienced personal injury attorney. A highly experienced personal injury attorney can walk you through the entire process of acquiring your settlement proceeds. They can help you easily comprehend the complicated tax rules surrounding your compensation.

Hiring a good attorney can also help you create an effective settlement agreement. They can help you avoid delays in getting your funds and avoid settlement taxes. An attorney with a vast knowledge of taxation law can provide astute legal advice to help you minimize or completely eradicate taxes on your settlement fund.

Our personal injury attorney at The Soffer Firm Miami Personal Injury Attorneys has the necessary skillsets to help you achieve the best outcome for your case. Our Miami attorney has a proven background in helping clients avoid the tax consequences for their settlement.

At The Soffer Firm, we know exactly the situation you are facing, and we understand the goal you want to achieve for your case. We guarantee the best result in every case we handle. Settlement taxes are not new territory to us. We have years of successful experience in handling out-of-court settlements.

If you are interested in our service, call us at (786) 788-7344 for a free case consultation. You may also fill out this form on our website. You can also check our webpage for other services we offer.