Are Lawsuit Settlements Taxable?

Are lawsuit settlements taxable? Sometimes. If you're expecting a lawsuit settlement and you want to know if the money is taxable, it’s good to learn about the IRS rules and reasoning for how to treat damages awarded in lawsuits. The best way to learn how the settlement could affect you is to discuss your situation with a qualified tax professional. 

Here are some general details.

Settlements and Tax Liabilities

The IRS is mostly focused on collecting income taxes. A settlement that’s awarded to cover lost or reduced income could be taxable. That money is replacing your taxable personal income. On the other hand, lawsuit settlement money awarded to cover current and future medical expenses is typically not taxed as income. These funds are reimbursing you for costs you have paid or expect to pay.  

How much tax do you pay on lawsuit settlements? It depends on the nature of your damages (the loss you suffered) and how your settlement is structured. You and your attorney should plan carefully when you prepare a lawsuit and accept a settlement, so you aren’t surprised by what you owe the IRS.

Let’s look at a few situations when lawsuit settlements are taxable—and what it might mean for your personal finances.

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When Are Lawsuit Settlements Taxable?

If you’re a plaintiff involved in a lawsuit (you sued someone), you may feel happy and relieved if the court decides in your favor or the suit is settled to your satisfaction. But you may wonder: Is a court settlement or judgment taxable? You may be surprised to learn that many people must pay taxes after winning or resolving a lawsuit. 

According to the IRS, except in rare circumstances, all income is taxable. That includes income earned from a lawsuit judgment or settlement. If the claim stems from lost wages, then it's taxable. Emotional distress awards are taxable if the symptoms aren't physical. Punitive damages, awarded in court judgments, are always taxable.

When Are Lawsuit Settlements Not Taxable?

There are some types of lawsuit settlements that follow different IRS rules. This includes a car accident claim of personal injury or a work injury claim of worker’s compensation.

You won’t have to pay taxes on these three three types of lawsuit settlements: 

• Personal physical injury 

• Worker’s compensation 

• Non-disclosure agreements related to sexual impropriety 

Are Debt Settlements Taxable?  

Yes, there are often tax consequences of debt settlement. This type of settlement is considered taxable income unless you’re insolvent. Insolvent means the value of your debts is more than the value of the things you own.

If you need credit card debt relief or other debt settlement help, your lenders and creditors may agree to settle your debts by accepting a smaller amount of money than what you owe. The IRS treats forgiven debt the same as money that you receive. 

For example, if you owe $15,000 on a credit card and can’t pay your bills, you might ask the credit card company to accept $10,000 instead. If the creditor agrees to settle for $10,000, they’ll also report $5,000 of forgiven debt to the IRS. If you’re in the 12% tax bracket, you might owe $600 in federal income taxes for that debt settlement. 

If you’re insolvent at the time you settle the debt, you won’t have to pay federal income taxes on the forgiven debt.

Many people who pursue debt settlement are insolvent. There are many scenarios where your debts might exceed your assets. Here’s an example:

Charlie isn't insolvent. Charlie’s forgiven debt would be considered taxable income. That doesn’t mean Charlie shouldn’t pursue debt settlement, only that it’s a good idea to factor in the potential tax bill when choosing any debt strategy.

Sam is insolvent by $3,000. The first $3,000 of forgiven debt wouldn't be taxable. Sam should assume that forgiven debt above that amount could be taxed.

Note that at Freedom Debt Relief, we aren’t tax pros. We can’t advise you on your specific tax situation. You can get a sense of what the IRS is looking for by reviewing Publication 4681. It includes a worksheet to determine insolvency. Consult a tax professional who can help you make sure your worksheet is complete and correct. 

Getting a big windfall of money from a successful lawsuit or negotiating an agreement with your creditor can be a huge relief for your personal finances. But make sure you have a plan for the tax consequences. 

IRS Lawsuit Settlement Rules

The IRS has four basic rules that dictate the taxation of litigation settlements or judgments.

1. The origin of the claim. Settlements for physical injuries aren't subject to taxation. Emotional distress could be taxable if it didn't originate from bodily injury or sickness due to an accident.

2. Tax agreements. You and the defendant (the person you’re suing) could agree to allocate portions of a settlement to different categories of damages when some are taxable and others aren't. Such agreements aren’t binding on the IRS or the courts in later tax disputes, and could be ignored. But they’re usually honored.

3. Attorney fees. If you use a contingent-fee lawyer, all money you recover as a plaintiff could be taxed, including the contingency fee. That only applies to taxable settlements. With a physical injury case, for example, you won’t owe taxes on what you receive. 

4. Punitive damages. Suppose you were involved in a car accident and suffered injuries. You are awarded $60,000 in compensatory damages and $6 million in punitive damages. The compensatory damages are tax-free, but the punitive damages are fully taxable.

Rules for Plaintiffs vs. Defendants

Plaintiffs aren’t the only ones who have to be concerned about paying taxes on lawsuit settlements or judgments.

If someone sues you, you might lose or settle out of court. If you then sell some things you own in order to pay the judgment, those transactions could trigger taxes. For example, let’s say you’ve been working on a stamp collection and it’s worth more than the amount you’ve invested in it. The IRS would consider you a hobbyist because you purchased those stamps with the hope that they would increase in value over time. If you sell collectibles at a gain, that’s taxable income.

Taxable Attorney Fees

Regardless of whether you pay your attorney on a contingent-fee basis or by the hour, legal fees affect your tax obligations.

When there's a lawsuit settlement, the payor (the person or organization that lost) makes a payment to the person who won. Sometimes the payor also has to pay the other side’s attorney. 

In that case, the payor will report the payment to you and the attorney’s fees on separate forms to the IRS. For this type of situation, you as the winner wouldn’t report the attorney’s fees to the IRS. 

The tax reporting situation is slightly different if you use a contingent-fee lawyer, who only gets paid based on winning or settling your lawsuit. If you receive an award that was won or recovered by a contingent-fee attorney, the entire amount will be reported to the IRS, including the portion you have to give to your attorney. This could increase your tax obligations or require you to manage a more complicated tax return. 

Damages related to physical injury or sickness aren't taxed. But if you receive payments from other types of lawsuit settlements, be sure to contact a professional accountant or tax advisor who can help you understand your tax obligations. 

Other Expenses Involved

Taxes aren’t the only things you may have to pay if you are involved in a lawsuit. You might have to pay court fees, as well as for any expert opinions or reports that you solicit to back up your claim. 

For some people, it’s possible to deduct certain litigation costs from your taxable income in the year you paid them. 

When Taxes Are Due

If you owe taxes related to a lawsuit settlement or judgment, you’re expected to pay those taxes when your return is due for the tax year in which the settlement or judgment was reached.

If your tax year finishes on December 31, your tax return is usually due on April 15 of the following year.

Additionally, be aware that taxes will only be withheld from the money that’s sent to you if the person paying you is legally obligated to do so. If that doesn’t  happen, you’re responsible for paying the taxes yourself. When you file your taxes, you're expected to provide a plan for payment of any outstanding taxes if you can’t pay them when they’re due.

How to Avoid Taxes on Lawsuit Settlements

If it is clear that your claim is taxable, work closely with an experienced tax attorney to manage the impact on your personal finances. Work with an attorney who has experience in participating in settlement conferences and knowledge of tax rules.

If you have a tax planner or tax attorney, loop them into the conversation as well.