Are Settlements Taxable? A Brief Guide

MAAC StaffJune 6, 2018
are settlements taxable?

The entire legal process from first filing a claim to finally receiving a jury verdict or settlement can sometimes seem like it drags on forever, especially if a lawsuit goes to trial. When all is said and done, plaintiffs feel relief and just want to move forward with their lives as best they can.

But as much as one wants to put the legal process out of sight and out of mind, it’s important to stay organized with all the documentation and be prepared to file your tax return properly. Many plaintiffs wonder if their settlement is taxable, but unfortunately, there is no simple answer. The IRS has various laws in place, many of which also have various exemptions and clauses that influence what part of the settlement, if any, is taxable.

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Are Lawsuit Settlements Taxable? Personal Injury vs Wrongful Death

Firstly, claimants need to be aware that whether they receive a jury verdict (compensation awarded by jurors in the event that the claim goes to trial) or a settlement (compensation agreement that often occurs before trial), the same tax laws apply. The IRS, however, does denote some differences between personal injury and wrongful death claims.

Personal injury claims can be filed for a number of reasons, like injury as a result of a car accident, an accident in the workplace, or a disease like mesothelioma. Whatever the reason behind the claim, if the financial compensation was awarded because of a specific physical injury or physical illness, the settlement is exempt from being taxable income.

However, plaintiffs awarded compensation for personal injury claims aren’t necessarily completely free and clear of paying taxes. The IRS tax code states they must claim any portion of the settlement that was deducted in previous years for medical costs for tax benefits. Any such deductions should be reported as “Other Income” on the tax form.

Wrongful death claims, or those filed by surviving family members, can become a little more complex when it comes to paying taxes. In general, wrongful death claims are also typically exempt. For those in certain states, like Alabama, only punitive damages are determined in such claims. In most cases, the settlement would then be taxable. The IRS, however, allows for exemption in these states, rather than taxing the entire settlement.

When is the Settlement or Verdict Taxable?

Unfortunately, these laws aren’t always so black and white, and it can sometimes be difficult for plaintiffs to know when their compensatory damages are clear or considered taxable. In general, the tax treatment of awards and settlements fall into several categories that can help plaintiffs determine if part or all of the compensation can be taxed.

Emotional Distress

One particular grey area many face when it comes to tax time is the consideration of emotional distress. For many, a physical injury, an exposure in the workplace or an injury caused by another person or product can bring about a great deal of stress, trauma, and all kinds of other emotions. However, the IRS changed tax laws back in 1996 to state that only a “personal physical injury or physical sickness” is considered exempt. Even physical symptoms as a result of one’s emotional state, like stomach disorders or insomnia, would still be considered taxable in most cases as the emotional distress is a non-physical injury.

At the same time, emotional distress damages may not always be completely taxable either. Regulations allow deductions for the amount of money paid out-of-pocket for medical expenses related to such issues, like therapy, as long as it hasn’t been previously deducted in prior years.

Punitive Damages

There are also instances in which part of the settlement may be taxable. In a mesothelioma lawsuit against an asbestos company, for example, the plaintiff may receive an award for the company’s negligence that led to asbestos exposure and an eventual diagnosis. While a jury may award compensatory damages in line with the mesothelioma victim’s medical expenses, lost wages, and pain and suffering, they could also potentially award punitive damages.

Punitive damages are an additional award meant to punish the defendant and help set an example. Under a 1996 amendment to regulations, punitive damages are also considered taxable in most instances.

Ordinary Income

Even in personal injury lawsuits that are typically considered exempt, there may be some instances where plaintiffs are required to claim part of their settlement proceeds. In general, portions of settlements attributable to one’s income, like severance pay, back pay or front pay, are considered taxable because it is still “ordinary income.” The same can be said for a business in a lawsuit for lost profits; any portion of the settlement amount attributable to net earnings or self-employment wages would be considered ordinary income, and the plaintiff is required to pay taxes on it.

Other Instances of Taxable Settlements

  • Interest on any settlement (whether lump sum or settlement payments)
  • Most payments for lost wages or lost profits
  • Settlements of pension rights (divorce cases)
  • Employment discrimination compensation
  • Injury to reputation awards
  • Damages for Title VII (Civil Rights Act)

Attorney Fees and Taxes

Plaintiffs must also pay attention to how they handle their attorney’s fee when filing their taxes, especially in regard to a contingent fee. For example, a reputable mesothelioma law firm will generally take on a new case on a contingency basis. That means a claimant will not need to pay the lawyer upfront, but only in the event that the case is successful.

So if a legal settlement agreement was for $400,000 and the lawyer takes 40%, many would think their added income was only the remaining $240,000 after these fees. But, the IRS still requires plaintiffs to mark down the entire settlement or verdict total before the contingency fee as gross income for tax purposes.

Overall, tax laws can be complex and confusing. Plaintiffs should work with a tax professional or CPA to ensure they file correctly and don’t over or underpay taxes on their settlement or jury award.