Earning financial compensation after an accident can feel like a weight off your shoulders. That chapter of your life is finally closed, and you can start moving forward. With tax season right around the corner, you want to ensure you have your ducks in a row so you don’t miss anything. If you successfully filed a personal injury settlement that year, does it contribute to your taxes? Are lawsuit settlements taxable?
Luckily, Compass Law Group, LLP, has experience working through settlements and the aftermath. We’ll cover the general taxation rules for lawsuit settlements, which are taxable and which aren’t, and what you need to do to prepare for tax season with a settlement.
General Taxation Rule for Settlements
The Internal Revenue Service (IRS) is responsible for collecting taxes each year and ensuring you file properly. In general, all income you earn is taxable and must be reported in your annual tax file. According to the Internal Revenue Code (IRC) Section 61, all income must be taxed unless explicitly listed as an exemption.
In short, some lawsuit settlements are taxable, and others are not. It can be tough to determine which category your settlement falls under, so we’ll provide a quick summary of the non-taxable and taxable lawsuit settlement types.
Non-Taxable Settlements
Knowing whether your lawsuit settlement is taxable or not can ease the headache that comes with filing your yearly taxes. The three types of settlements that are non-taxable include personal injury and physical sickness settlements, workers’ compensation benefits, and emotional distress settlements related to a physical injury.
Personal Injury & Physical Sickness Settlements
IRC Section 104(a)(2) states that settlement money earned from personal physical injuries or sickness is not taxable income. Simply put, if there are visible signs of injury or sickness, and you receive compensation for those injuries, you won’t have to pay taxes on them. They don’t need to be added to the income portion of your taxes.
There is also a medical reimbursement rule for these types of settlements. If you didn’t deduct any medical expenses in prior years, the settlement money from personal injuries is not taxed. In other words, your settlement won’t be taxed if you’ve not added medical expenses to your tax deduction section in the past.
Workers’ Compensation Benefits
In general, the IRS doesn’t consider workers’ compensation as taxable income. Worker’s compensation covers medical expenses, illness, loss of income, and disability benefits after a workplace accident. For this reason, it’s not added to your yearly taxes.
There is one exception to this rule. If your workers’ compensation settlement includes punitive damages, those damages are taxable. Settlements that include extra payouts as punishment for negligent behaviors are always considered taxable by the IRS.
Emotional Distress Settlements
When filing a personal injury case, you can also earn compensation for emotional distress caused by the accident. As long as these emotional damages are directly related to a physical injury settlement, then the IRS will not tax it. There needs to be clear evidence that the emotional distress was caused by serious personal injuries.
The IRS makes a clear distinction between physical and non-physical emotional distress. You can earn emotional distress settlements for non-physical injuries such as defamation and humiliation, and these settlements would be considered taxable.
Taxable Lawsuit Settlements
While the settlements we mentioned earlier are exceptions to the rule, other lawsuit settlements are still considered taxable income and will need to be a part of your filing process in April. It can be confusing to keep track of each, so we’ll go over the list briefly.
The list of settlements that are going to be taxed includes:
Punitive Damages
Punitive damages are essentially fees added to your settlement designed to punish the defendant for negligent or harmful behaviors that led to the incident. Because of this, they are always taxable. If you earn any amount of punitive damages, regardless of the settlement as a whole, you will need to pay taxes on those damages.
The only exception to this rule is in the case of a wrongful death case. If the incident results in a wrongful death, and that’s the primary focus of the settlement, punitive damages are allowed under state law and will not be taxed.
Lost Wages
Settlement payments meant to cover lost wages, whether past or future, are treated the same as your regular income. The IRS lumps this settlement into your normal annual income, so it’s subject to the standard taxation as your income. This can include income tax, Social Security, and Medicare taxes.
Interest in Settlements
Your lawsuit can develop interest before settlement as well as afterward, and the IRS views this interest as part of your regular income. They view it as you making money from the lawsuit, hence, it will need to be taxed. It’s similar to how they tax the interest you earn on a savings account since you’re making money from it.
As mentioned earlier, emotional distress damages from a physical injury aren’t considered taxable income. However, in cases where the injury isn’t physical, such as defamation, any emotional distress damages you earn are taxable. If you want a better idea of what that will look like for your specific case, the general formula for taxable settlements includes:
The Taxable Amount = The Total Settlement – Any Unreimbursed Medical Expenses for Emotional Distress
Tax Planning for Settlements
Earning a large settlement after filing a legal claim can be both rewarding and frustrating. On one hand, you got the compensation you deserved to cover your damages, but on the other hand, this just made your yearly taxes that much more difficult.
It can feel overwhelming to try and get your documentation in order and figure out what needs filing and what doesn’t, and we’re here to help as much as we can. Proper preparation before tax season can set you up for success and ensure your filing process isn’t too complicated.
Here are a few things you can do to make the process a little smoother and less stress-inducing:
Structuring Lawsuit Settlements for Favorable Tax Treatment
You can start making tax filing easier for yourself during the settlement process. As you’re negotiating your compensation, you can choose between a lump sum settlement or a structured settlement. The amount will not change, but which you choose will change how you earn the money.
In a lump sum settlement, you get all of the money at once as one big chunk of change. In a structured settlement, you get the money incrementally over time.
Whichever you pick will impact the classification of your settlement and how you go about filing your taxes for the year. Structured settlements can have a less complicated process for adding it to your taxes, while a lump sum may result in a higher tax payment.
The Role of Settlement Agreements
While negotiating your settlement agreement, you’ll need to clearly define all of your damages and how they pertain to the incident. Proper documentation of all your damages can make it easier to keep track of everything and know which damages need to be taxed and which do not. This not only helps you file your taxes, but it also creates a paper trail that the IRS can follow to track party intent during the settlement agreement.
Tax Withholding and Reporting Requirements
If your settlement is classified as taxable income, then you should receive a 1099 form to fill out as a part of your annual taxes. This form will document the settlement amount and its classification, and you can add it to the documents you’ll need for your annual taxes.
You may also receive a 1099 or W-2 form for attorney fees paid during the settlement process. In some cases, you may be able to add attorney fees as a part of your tax deductibles.
Navigating the Tax Implications of Lawsuit Settlements
Filing your taxes is stressful enough, let alone with the added complexities of a lawsuit settlement. While there’s a ton of information to go through, the key takeaway is that some settlements are taxable while others aren’t.
Personal injury settlements with physical injuries are non-taxable, while others, like punitive damages and lost wages, are taxable. You can also reduce your tax burden by going with a structured settlement rather than a lump sum settlement.
If you’re looking to earn a legal settlement after a serious incident, Compass Law Group, LLC, is ready to join the fight. We’ll make sure you get the compensation you deserve while setting you up for success when tax season approaches.
Contact us today to schedule a free consultation and see what your current options are for legal proceedings.
