Winning a settlement in a personal injury case, divorce settlement, or civil suit can help you get back on your feet and compensate you for the harm you suffered. You can use your settlement to pay medical bills and other case-related expenses and support yourself while you recover or rebuild your life.
You may wonder, “are settlements taxable”? when you win a large sum following a legal or civil case. Learn what portions of your settlement may be tax-free, which parts you may owe taxes on, and how to minimize tax liability on your compensation.
How Income From Lawsuit Settlements is Taxed
Understanding “are settlements taxable” requires knowing what the IRS considers ordinary income and how it is taxed regarding settlements. The IRS states in Section 61 of the Internal Revenue Code (IRC) that all income is taxable unless it qualifies for exemption under another section of the IRC, regardless of the source of the income.
Income from settlements, awards, and lawsuits is taxable unless it meets one of the specific exclusions in IRC Section 104.
To determine if income from a lawsuit settlement qualifies as non-taxable, the IRS will consider the facts and circumstances of each settlement payment. The IRS considers proceeds from most lawsuit settlements to be income, which is taxable under IRC Section 61.
The most commonly-cited exception is personal injury settlements, which are typically non-taxable. Certain emotional distress settlements that involve actual damage are also considered non-taxable. Additionally, the IRS does not consider proceeds from insurance settlements to be income and will be non-taxable in most cases.
In many situations, the IRS will only tax a portion of the proceeds from a settlement. For example, in settlements involving emotional distress, the IRS may consider a percentage of the settlement as non-taxable if the plaintiff can prove that the distress involves physical injury.
Example: Jonah develops PTSD after a bad car accident. If he can prove that the negligent behavior of the other driver directly led to his development of the condition; the IRS may consider a portion of his settlement proceeds non-taxable, even if the source of his claim was his emotional distress.
Taxpayers may also be able to lower the taxes they owe on settlement proceeds. For example, if a plaintiff paid medical expenses related to emotional distress in prior years but did not deduct the payments on their tax return, they will pay less taxable settlement proceeds.
Learn how the IRS tax proceeds in legal settlements, like back pay, payment for personal injury, and punitive damages.
Back Pay
In employee-related lawsuits, such as involuntary termination or unlawful discrimination suits, employees who win their cases may receive compensation for lost wages in the form of back pay, front pay, or severance pay.
In employment-related lawsuits, the IRS considers the portion of your proceeds to cover your lost wages taxable. As a form of compensation for lost wages, you must pay taxes on back pay and report it as income on your tax return.
Example: Abe is awarded $10,000 in the form of back pay after a successful unlawful discrimination lawsuit. Since the IRS considers back pay settlement proceeds as wages, Abe must report it as ordinary income and pay taxes on the back pay. His employer should send him a W-2 that reflects withholding federal and state (if applicable) taxes as well as FICA taxes.
Personal Injury
If you are injured or sick, you may receive a settlement to help compensate for lost wages and pay medical bills.
If you did not deduct medical payments related to your injury or sickness in previous tax years, the full amount of your settlement is non-taxable. You should not include proceeds from the settlement on your tax return.
If you did deduct medical payments in prior tax years, you need to include the portion of the settlement you deducted for these payments as income to the extent that these deductions offered tax benefits.
If you made these payments over multiple years, part of the proceeds for your medical bills must be allocated on a pro-rata basis to each of the years you made medical payments, as detailed in IRS Publication 525. These taxpayers should report the tax benefit amount on Form 1040, Schedule 1, under “Other Income.”
Example: Bella was injured at work and received a settlement of $50,000. Since her injury was sudden rather than chronic, she has not deducted any medical payments for the injury in prior tax years. Bella’s settlement is non-taxable if the entire award goes towards medical care, such as hospital treatment, physical therapy, and medication to treat the injury.
Emotional Distress
You may also receive proceeds from a settlement to compensate for emotional distress or mental anguish. If these proceeds are attributable to sickness or personal injury, the IRS will consider them non-taxable, like settlements involving personal injury. Settlements earmarked for medical expenses that stem from emotional injuries won’t be taxed.
If the proceeds you receive in an emotional distress settlement cannot be attributed to physical sickness or injury, they are considered taxable, and you must include the proceeds in your income. The amount of these proceeds you must include in your income can be reduced by:
- Payments made for medical expenses related to emotional distress you have not previously deducted.
- Medical payments related to your emotional distress that you previously deducted but did not offer a tax benefit.
You can calculate the taxable proceeds from emotional distress settlements unrelated to physical injury using this calculation:
Entire settlement amount – (related medical costs not previously deducted) – (deducted medical costs with no tax benefit) = taxable proceeds
Example: Cole received $50,000 in proceeds as a settlement in an emotional distress lawsuit. Cole has been feeling mental anguish and has paid $10,000 in medical expenses in the last few years, none of which he has deducted from his income.
Since Cole’s emotional distress settlement payments are unrelated to physical illness, all the proceeds from the settlement are taxable except for his non-deducted medical payments related to his distress ($10,000). Cole must only pay taxes on $40,000 of the settlement proceeds. He should report the net taxable amount on Form 1040, Schedule 1, under “Other Income.”
Punitive Damages
Punitive damages are payments a guilty defendant must make on top of paying any compensatory damages. Punitive damages are typically awarded when the compensation to the injured party is deemed insufficient or to punish the defendant for grossly negligent or intentional criminal behavior.
Because punitive damages aim to deter further criminal behavior and set an example for others, punitive damages can be quite high. The amount an individual must pay in punitive damages will depend on the nature of their behavior and state.
Some states cap the amount of punitive damage. For example, Alabama statute limits punitive damages to $500,000 or up to three times the compensatory damage owed. Other states, such as Arizona and Iowa, have not set a cap on punitive damages. Arizona even has a law prohibiting the establishment of a damage cap in cases involving wrongful death or personal injury.
Many states fall somewhere in the middle. In Louisiana, punitive damages are allowable in circumstances involving drunk driving, criminal sexual activity with minors, and toxic waste disposal, but not in most other situations. As stated in IRS Publication 4345, punitive damages are always taxable, even those received in a settlement for physical sickness or injury. Taxpayers should report these damages as “Other Income” on Schedule 1 of Form 1040.
Example: Dana gets drunk at a party but decides to drive home anyway, despite having multiple DUIs on her record. While driving in her home state of Virginia, she strikes a law-abiding pedestrian. While investigating the accident, it is determined that Dana’s BAC is 0.3. Under Section 8.01-44.5 of the Virginia state law code, any driver with a BAC of over 0.8 can legally be awarded punitive damages in a settlement.
The court will consider Dana’s actions and prior DUIs to determine the punitive damages she owes. This amount cannot be over $350,000, the Virginia cap on punitive damages.
Settlement Interest
When a settlement is awarded to a recipient, the at-fault party must pay proceeds to the damaged party. These proceeds often come with interest, which is considered taxable.
There are two types of interest involved in settlements: pre-judgment interest and post-judgment interest.
Pre-judgment interest accrues between the time when the injury or damage occurred and the time of the legal judgment. Post-judgment interest accrues between the time of the legal tax judgment and when the settlement is paid.
Keep in mind that even if you win a settlement, you may not see the proceeds for several weeks, months, or years, depending on the complexity of your case. For this reason, some plaintiffs prefer a structured settlement payout that allows interest to accrue on their proceeds over time, leading to a higher total payout.
Other plaintiffs choose (or require) the security of a lump-sum payment. Although lump-sum payments do not have time to gain value in interest, the payout is more immediate.
You must work with your lawyer to determine your pre-judgment interest rate. Your state will set its interest rate for your settlement, which accrues until you receive the money. For example, the pre-judgment interest rate in California is 10%, and in Colorado, it is 9%, compounded annually.
Similarly, you must work with your attorney to understand the post-judgment interest rate for your settlement, as each jurisdiction varies per state and timeframe. For example, the California rate for post-judgment settlements is 3.91% beginning on September 16, 2022, and the Kansas rate was 4.25% from July 1, 2021, to June 30, 2022. Judgments will have post-judgment interest from the date of the judgment until the settlement proceeds are paid.
The US court system has statutes governing the three categories of legal judgments, which further detail the nuances of interest rates in specific proceedings.
- Civil and bankruptcy adversary judgments (28 U.S.C. 1961)
- Criminal judgments (18 U.S.C. 3612(f)((2))
- Deficiency judgments in condemnation proceedings (40 U.S.C. 3316)
Both pre-judgment and post-judgment interest are taxable to the recipient. Taxpayers can report this interest as “Interest Income” on line 2b of IRS Form 1040.
Example: Ed wins $200,000 in a personal injury settlement after being injured in a car crash that was not his fault. Ed is comfortable financially, so he agrees to a structured settlement in which the at-fault driver agrees to pay a portion of the compensatory damages each month for five years.
Ed took the deferred payment option to accrue interest on the settlement, but the total amount will vary depending on your state and fees. Most states have default rates for settlements, but these can be changed to agreed-upon amounts regarding the contract signed.
The rates can also vary depending on if they are pre- or post-judgment, as well as when the contract or state law determines which rate will be used. Ed is happy with this situation because he knows post-judgment interest will accrue on the unpaid balance of the judgment.
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Taxable Legal Settlements
Most of the time, the IRS considers proceeds from legal settlements to be income. As stated in IRS Publication 525, proceeds from legal settlements are considered taxable income unless they meet a specific IRS exemption. Most of the specific IRS exemptions pertain to settlements from personal injury cases, which the IRS considers non-taxable. Taxpayers must report all taxable income on their yearly tax return.
To determine whether a settlement is taxable, you first need to understand how the IRS categorizes legal claims.
For tax purposes, the IRS divides legal settlements and awards into two categories: claims from physical injury and non-physical injury. Within each category, claims can be further divided into:
- Actual damages
- Emotional distress
- Punitive damages
It is important to remember that your claim is your cause of action, the reason behind your lawsuit. If you are seeking compensation for actual damages like a physical injury or property damage, your settlement will receive different tax treatment than settlements for emotional distress without physical damage. Whether or not your legal settlement is taxable depends on how the IRS categorizes your claim.
Most settlements in which physical damage occurs are non-taxable, but the IRS will tax the following in most cases:
- Proceeds from settlements involving emotional distress
- Punitive damage incurred during legal proceedings
- Settlement insurance
Emotional Distress
The IRS differentiates between so-called “actual damage” and emotional distress for tax purposes. Most settlement cases that don’t involve clear physical damage, whether to another person or their property, are taxable.
With regard to emotional distress settlements and taxation, the IRS requires payment on some forms of emotional distress while not on others. According to IRS Publication 4345, if your emotional distress, defined as an adverse emotional response to an event, is the result of your physical injury, your settlement isn’t taxable.
The funds are taxable as other income if you receive compensation for emotional distress not caused by injury or sickness. This situation may include emotional anguish resulting from witnessing a traumatic event or suffering non-physical discrimination or humiliation. You can reduce your tax liability in this case by subtracting the cost of medical bills you paid and did not deduct.
The following settlements tend to involve emotional distress:
- Discrimination settlements
- Wrongful termination settlements
- Some civil settlements
- EEOC settlements
Proceeds from emotional distress settlements are non-taxable if they can be attributed to personal physical sickness or injury. If there is no clear personal or property damage involved, the IRS taxes proceeds from settlements involving emotional distress in most cases.
Remember that even if the IRS considers the proceeds from your settlement to be taxable income, you may still be able to reduce the taxes you owe. You can reduce both payments you have made for medical expenses related to your emotional distress (i.e., to a therapist) and medical payments that you have deducted previously but that did not offer a tax benefit.
For an emotional distress case to be non-taxable, the plaintiff must prove that the defendant’s actions led to physical illness or injury. If there’s no form of physical injury or property damage, the settlement will be taxable in most cases. The question is: where is the line between emotional distress and personal injury?
Differentiating between physical and emotional damage can get confusing since emotional distress often comes with physical symptoms like insomnia, stomach disorders, and headaches. The key to understanding the difference is to look at the cause or root source of the physical sickness.
In most instances, if your emotional distress leads to physical sickness, the IRS will consider your settlement taxable because your emotional distress caused your illness, not the defendant’s action. On the other hand, if your claim that a defendant’s actions caused you to get sick is successful, your settlement (or a percentage of it) is non-taxable in most cases.
The following real-life example shows how one woman received a partially non-taxable settlement by proving that her employer’s actions led to her emotional distress.
Example: Domeny vs. Commissioner (2010)
In Domeny v. Commissioner, the plaintiff, Ms. Domeny suffered from multiple sclerosis (MS), a disabling nervous system disease. Ms. Domeny alleged that workplace problems (including an embezzling employer) worsened her symptoms in her case. When her doctor told her she was too sick to work, she was terminated, causing her MS symptoms to worsen. When Ms. Domeny was awarded a settlement for her employment case, a percentage of the proceeds were considered non-taxable because her employer’s actions caused her condition to worsen.
As the example illustrates, receiving a non-taxable or partially non-taxable settlement in an emotional distress case is possible.
The situation becomes even more complicated in cases involving sexual abuse and harassment. As of December 2017, the IRS prevents tax deductions for sexual abuse and sexual harassment settlements subject to nondisclosure agreements.
Many taxpayers are clamoring for clarification on the taxability of sexual abuse and harassment settlements. It is both sensitive and complicated to differentiate between physical and emotional damage when sexual abuse is involved. Many more believe sexual abuse should qualify as personal injury and that the IRS shows inconsistent behavior by taxing sexual abuse settlement proceeds but not proceeds from, say, a slip-and-fall accident.
Punitive Damages
Punitive damages are taxable, even those received in a personal injury or sickness settlement. In a legal settlement, the guilty party must pay punitive damages on top of any compensation damages agreed upon in the settlement.
Punitive damages are often awarded in personal injury cases, as these cases involve harmful or negligent behavior. Although most portions of personal injury settlements are non-taxable, any punitive damages you are awarded during the case still are, no matter whether or not you were awarded compensation in the proceedings.
Settlement Interest
Most settlement payments come with interest, and this interest is often taxable. The IRS taxes interest on any settlement as “Interest Income.” Taxpayers can report interest income on line 2b of IRS Form 1040.
Interest can accrue on a range of compensations or damages from settlements, including:
- Lost wages or lost future income
- Medical expenses (present and future)
- Emotional distress/pain and suffering
The amount of interest accrued by these settlement proceeds will differ based on how the payout is arranged. For example, in structured settlements, the defendant pays the plaintiff the settlement proceeds in installments for a specific period. Since the proceeds will earn interest over time, payments are often increased to keep up with inflation. Overall, structured settlements lead to a higher payout than lump-sum settlements.
Non-Taxable Legal Settlements
The majority of non-taxable legal settlements involve some sort of personal injury. This could be a physical injury from a slip-and-fall accident, a sickness caused by negligence, or physical damage to your property. If you can prove “actual damage,” you have a case for a non-taxable legal settlement.
Let’s take a closer look at what settlements involve personal injuries and if they qualify as non-taxable.
Actual Damages
Personal injury and physical sickness are considered “actual damages.” As long as the taxpayer did not deduct medical payments related to their injury in past tax years, the settlement proceeds are non-taxable. Any portion you have deducted for medical payments related to your injury in past years counts as taxable income to the extent that the deductions brought about tax benefits.
The following settlements often involve actual damages and are non-taxable in most instances:
- Personal injury settlement
- Workers’ compensation settlement
- Retaliation settlement
- Bodily injury settlement
- Car accident settlement
- Mesothelioma/asbestos settlement
- Medical settlement
- Property damage settlement
- Structured settlement
- Wrongful death settlement
- Police settlements
- Some civil settlements
- Clergy abuse settlement
- Roundup settlement
- Tort settlement
Insurance Settlements
Money received from insurance settlements is also non-taxable because the IRS does not consider this money to be income. In the eyes of the IRS, insurance settlements are meant to bring the plaintiff back to baseline financial stability. In other words, they are not a means of increasing wealth.
Most insurance settlements that involve repairing or replacing your property (i.e., car, home) are tax deductible.
Example: Frances owns a $20,000 car that is totaled in an accident. If she is awarded a settlement of $20,000 to pay for a new car, she does not owe taxes on the settlement since, technically, she hasn’t gained any income.
Viatical settlements are legal settlements in which a person with a terminal or chronic illness sells their life insurance policy for a cash payment. Since life insurance benefits are not taxable, neither is the payout from a viatical settlement. Remember, the IRS does not consider insurance to be income. If you’re wondering if the life insurance proceeds you received are taxable, you can start by completing the Interactive Tax Assistant Questionnaire created by the IRS.
Keep in mind that while the proceeds from a life insurance settlement are not taxable, the interest on these proceeds is taxable.
Divorce Settlements
This same situation applies to property transferred in the course of a divorce. As long as the property transfers are incident to the divorce, they cannot be taxed. The IRS considers property transfers made within the year after the marriage end date to be divorce-related.
Considerations with Legal Settlement Taxation
The IRS taxes all settlement proceeds and damages collected unless they qualify as tax deductible. The same rules apply no matter where the settlement takes place, how many people it involves, and the payment method of the settlement proceeds.
Each of the following settlements may be tax deductible if the plaintiff can prove actual damage:
- Court settlements
- Out-of-court settlements
- Litigation settlements
- Class action settlements
- Cash settlements
Remember that the IRS considers settlements involving “actual injury” non-taxable. When the lines between physical and emotional damage are blurry, it can help get a tax expert involved and a lawyer. Tax Shark offers a tax review service that defends the interests and wallets of its clients so you can take advantage of your available deductions and reduce the amount of taxes you owe.
How Attorney Fees Are a Taxation Trap
During a legal settlement, the plaintiff must make payments to the IRS and their attorneys or legal counsel. In prior years, plaintiffs could deduct a portion of their attorney fees from their taxes, thereby reducing the taxes owed on their settlement.
The Tax Cut and Jobs Act (TCJA), enacted in 2017, changes taxation requirements for plaintiffs. It states that attorney fees are no longer deductible. This means plaintiffs must pay taxes on all proceeds from a settlement, even on amounts paid to a lawyer they never see. Depending on the contingency fee rate and applicable state and federal tax rates, a successful plaintiff can receive less than 20% of their settlement proceeds.
This situation is called the “contingency fee tax trap,” in part because contingency fees can be high. Contingency fee arrangements establish the fixed percentage of the recovery proceeds the attorney is entitled to should they win the case. Lawyer fees may account for 30% to 40% of the total proceeds, but many states limit the fees to 33% in their statutes.
Recently, lawyers in some states have united to declare these high contingency fees unethical. In an interesting turn of events, a cohort of lawyers has filed petitions to reduce contingency fees with several state supreme courts, ethics commissions, and bar associations. So far, petitions have been filed in the following states:
- Alabama
- Arizona
- California
- Colorado
- Maryland
- Mississippi
- New Jersey
- New York
- Ohio
- Oklahoma
- Utah
- Virginia
Can I Deduct the Legal Fees?
In most cases, you cannot deduct legal fees paid to an attorney for assistance in a lawsuit settlement on your tax return. If your case involves a personal legal issue, you must pay taxes on your attorney payments. Settlements involving personal legal matters include:
- Personal injury settlements
- Divorce settlements
- Emotional distress settlements
- Civil settlements
- Sexual abuse or harassment settlements
- Property damage settlements
The exception is fees paid to an attorney for legal issues pertaining to business. The IRS considers legal payments for business matters, like drawing up a business contract, to be a business expense. As detailed in IRS publication 535, payments made by a business to an attorney for legal services are tax deductible.
Why Your Settlement Agreements Should Specify How Proceeds Are Taxed
The IRS taxes different settlements in different ways, so it’s important that your settlement agreement specifies how the proceeds should be taxed. The IRS can classify the proceeds if your agreement doesn’t designate a taxation method for the proceeds (i.e., taxed as wages, actual damages, attorney fees, etc.).
While the IRS does not consider settlement agreements binding, they won’t ignore them either. For the IRS to accept an agreement as binding for tax reasons, the agreement must be entered into:
- In an adversarial context
- At arm’s length
- In good faith
Example: Greg breaks his leg in a slip-and-fall accident and makes a claim to be compensated for his injury. Greg successfully demonstrates “observable bodily harm” since a broken leg is an observable injury. He, therefore, argues that his proceeds qualify as actual damages and not wages, which the IRS considers non-taxable. Although his case seems cut and dry, the IRS will still review court documents to determine the nature of the claim and the payment.
The IRS also establishes explicit reporting requirements for taxable proceeds from legal settlements. The primary methods of reporting settlement proceeds are Form 1099-MISC and Form W-2 (for employee wages subjected to tax withholding).
Tax Forms for Legal Settlements
Depending on your settlement type, you may have to fill out tax forms for the IRS. Assume that if the money you receive is taxable, you must file at least one form.
How 1099-MISCs for Legal Settlements Work
1099-MISC forms are used for miscellaneous income, which includes proceeds from legal settlements. While there is no section labeled for legal settlements, the “other income” section can be used in its place.
When You’d Get a 1099-MISC for a Legal Settlement
If you receive over $600 in a calendar year and the settlement money is taxable, expect to receive a 1099-MISC from the payer. An exception to receiving a 1099-MISC is if the settlement comes from back wages of a W-2 job. In that case, the income would be reported on a W-2, not a 1099-MISC. If you receive settlement interest, it is reported on a 1099-INT and is considered taxable income.
Example: Hester receives $10,000 in a discrimination settlement. The IRS considers her claim for emotional distress damages, as her case doesn’t involve personal injury or property damage. Hester’s settlement is, therefore, taxable. She will receive form 1099-MISC from the payer of the settlement proceeds.
Who Has to File Form W-2?
The other principal method of reporting settlement proceeds to the IRS is Form W-2, which involves reporting employee wages.
The IRS deems any settlement payments involving claims for back pay, front pay, or severance pay to be employee wages. Because these settlements stem from claims for wages, the IRS treats the proceeds as wages, which are taxable. An employee’s settlement wages are subject to tax withholding even if the employee no longer works at the job when the settlement is paid.
Tax withholding for wages must be reported on Form W-2. If the employer does not withhold and remit the appropriate amount of taxes, they may face additional liabilities, interest, or other penalties.
3 Key IRS Rules for Filing Taxes After a Settlement
The IRS exists to collect taxes, and that includes collecting taxes on settlements. Even so, there are some tips to know if you need to pay taxes and what you need to file if you do.
Tip #1
In most cases, physical injury, car accident injury, emotional distress awards, and medical expenses with no previous deductions are not taxable. If you took a deduction for medical concerns, a portion of these settlements must be listed as “other income.”
Tip #2
Punitive damages, interest, and lost wages are taxable. These settlement portions are taxable because they would otherwise be taxed or are additional non-medical related funds. If you received full or partial payment for wages, you need to include it on your IRS return.
Tip #3
Consult with a professional accountant regarding whether you need to pay taxes on your settlement and, if you do, which forms you are required to fill out. Your tax professional can help you understand your tax liability, including assessing any W-2 or 1099 forms you receive.
FAQs
Here are the answers to some common questions about the taxability of legal settlements.
While you can’t avoid paying taxes on a settlement altogether, you can minimize your tax liability with various strategies. These include spreading your payments out over time and seeking damages that aren’t taxable, such as non-deducted medical expenses.
Parts of a settlement that are taxable include medical expenses you deducted the previous year, punitive damages, wage compensation, and property damages on which you earned capital gains.
No, you will not receive a 1099 for your settlement in most cases. You may receive a 1099-MISC if your settlement includes lost wages, punitive damages, or other funds you must report as income.
Speak with your lawyer and a tax planning professional to determine how to report the funds to the IRS if you win a large settlement. It’s vital to meet your tax obligations, so you can use the remaining money to cover accident-related expenses and rebuild your life.
Yes, the IRS could potentially take your settlement money if you have back taxes. If your taxes are not paid in full, you could lose out on some of your settlement.
In most cases, lump-sum payments are not taxable in divorce settlements. Neither alimony nor property transfer lump-sum settlements are taxable as income for the recipient. You may pay taxes on property transfer settlements that happen six or more years post-divorce.
It depends. Most personal injury settlements are excluded from federal and state taxes; you must report your settlement if you used the same injuries for medical deductions, won punitive damages or wage compensation, or your property damage award exceeded the adjusted basis for the property replaced.
A W9 is required for a settlement to ensure that the payor can produce a 1099 at the end of the tax year and report all applicable payments. You must fill out the W9 with the requested information so the payor can fulfill their tax obligation and send you a 1099 per IRS regulations.
