Are Lawsuit Settlements Taxable?

Are lawsuit settlements taxable? Sometimes, they are, and sometimes, they’re not. How can you tell if your lawsuit settlement is going to be taxable? By having a basic understanding of the IRS’s reasoning for damages awarded in lawsuits. 

First, remember that the IRS administers income tax. So a settlement that’s awarded to cover lost or diminished income will most likely be taxable. While damages awarded to cover current and future medical expenses would not be taxed as income because it’s really reimbursing you for costs you have incurred or expect to incur.  

How much tax do you pay on lawsuit settlements? It depends on the nature of your damages and how your settlement is structured. You and your attorney should plan carefully when you prepare a lawsuit and accept a settlement or you could be surprised by what you owe the IRS.

When Is a Court Settlement Taxable?

If you’re a plaintiff involved in a lawsuit, you may feel great if the court rules 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 shocked to learn that you must pay taxes after winning or resolving a lawsuit. Settlements from lawsuits may be taxable, based on the nature of the claim and other factors.

Internal Revenue Code (IRC) Section 61 specifies that, except in rare circumstances, all income is taxable, including income earned from a lawsuit judgment or settlement.

“The general rule is that any accession of wealth, including those from settlements and lawsuits, is taxable,” explains Brad Biren, a tax attorney in Des Moines, Iowa.

Lyle Solomon, an attorney and financial expert with Oak View Law Group in Rocklin, California notes that interest on monetary awards, reimbursements for lost earnings, damages for patent or copyright infringement or breach of contract, and cash obtained for the settlement of pension rights are the most typical taxable compensations related to lawsuit settlements or judgments.

“If the claim stems from lost wages, then it is taxable. Emotional distress is also taxable if the symptoms are not physical. Punitive damages, awarded in court judgments, are always taxable, too,” says Rita Mkrtchyan, a senior attorney at Oak View Law Group.

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When Are Lawsuit Settlements Not Taxable?

However, the IRS has special exceptions related to the tax exclusion and/or treatment of three categories of claims.

“Claims involving personal physical injury, worker’s compensation, and non-disclosure agreements related to sexual impropriety are not taxable,” Biren says.

Note that any claim related to the physical body has been tax-excluded since 1986.

“This includes a car accident claim of personal injury and a work injury claim of worker’s compensation. Congress, the courts, and the IRS are all in agreement that it is in the public’s best interest to keep these categories excluded from taxation,” notes Biren.

IRS Lawsuit Settlement Rules

The IRS has four basic rules that dictate the taxation of litigation settlements or judgments, according to Solomon:

1. The origin of the claim. “Settlements for physical injuries are not subject to taxation by the IRS. Emotional distress is taxable only if it did not originate from bodily injury or sickness due to an accident,” Solomon continues.

2. Tax agreements. You and the defendant may agree to allocate portions of a settlement  among different kinds of damages when some are taxable and others are not. “For example, if you claim that the defendant failed to reimburse you for a business trip, there is a high chance the court will consider several things before settlement. The easiest way to save money on taxes is for the plaintiff and defendant to agree on tax treatment, “ Such agreements aren’t binding on the IRS or the courts in later tax disputes, however, and may be ignored.

3. Attorney fees. If you use a contingent fee lawyer, all money recovered as a plaintiff will be taxed – even the contingency fee. “For instance, let’s say you claim intentional infliction of emotional distress for $50,000 against your neighbor, and the suit gets settled for that amount. Your lawyer gets $20,000; you may think you have earned $30,000, but according to the law, you made 100% of your recovery – $50,000,” he says. That only applies to taxable settlements, however. With a physical injury case, you won’t owe taxes on your recovery. 

4. Punitive damages are taxable. Case in point: 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. “Although the compensatory damages are tax-free, punitive damages are fully taxable,” says Solomon.

Rules for Plaintiffs vs. Defendants

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

“Defendants who exchange assets or liquidate assets to pay a settlement must pay taxes on each of those individual liquidations if they trigger a taxable event,” Biren points out.

Taxable Attorney Fees

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

“The IRS mandates that when a payor makes a payment to an attorney for an award of attorney’s fees and a settlement awarding a payment that is includable in the plaintiff's income, the payor must report the attorney’s fees on separate returns with the attorney and the plaintiff as payees,” Mkrtchyan says. “Therefore, per American Bar Association guidelines, tax forms 1099-MISC and W-2 must be filed and furnished with the plaintiff and the attorney as payee when attorney’s fees are paid, even though only one check may be issued for the attorney’s fees.”

“In this case, the attorney fee is non-deductible on your taxes,” Solomon says. “If a plaintiff uses a contingent fee lawyer, in the eyes of the IRS he will be treated as receiving 100% of his award recovered by him and his attorney.”

As pointed out above, however, damages related to physical injury or sickness are not taxed.

Other Expenses Involved

Taxes aren’t the only things you may be required to pay if you are involved in a lawsuit.

“It is the responsibility of the plaintiff to pay all fees related to initiating a lawsuit. That means, at minimum, the cost to file the petition and the cost to serve process,” says Biren. The plaintiff is also responsible for paying for any opinions or reports from experts to back up your claim.”

Plaintiffs can expense the cost of litigation from their taxes in the year they incurred them if the plaintiff has a pass-through entity such as a corporation.

“But that same taxpayer would then have to claim that part of the settlement as income at the close of litigation,” Biren adds.

When Taxes Are Due

If you owe taxes related to a lawsuit settlement or judgment, you will be expected to pay those taxes when your tax 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,” Solomon says.

Additionally, be aware that taxes are only withheld if the possessor of the funds must do so.

“In the case of litigation, only a fiduciary, such as a trustee of a large class-action suit, would be obligated to withhold taxes,” says Biren. “If there is no fiduciary or other statutorily appointed party to withhold taxes, then the recipient taxpayer is personally responsible for paying the applicable tax for the filing year the funds were received.”

Upon filing your taxes, you are expected to provide a plan for payment of any outstanding taxes, at a minimum.

“If you ever find yourself in a position where paying the outstanding tax bill is untenable, the IRS will work with you to create a payment schedule,” notes Biren.

How to Avoid Taxes on Lawsuit Settlements

If it is clear that your claim is taxable, work closely with an experienced tax attorney.

“Always ask whether your attorney has experience in participating in settlement conferences and their knowledge on tax rules,” recommends Mkrtchyan.

Also, request that your attorney communicate with your tax planner or separate tax attorney.

“This collaboration may give your attorney more information that could be used to creatively negotiate a settlement, including a settlement that won’t trigger taxes for you,” suggests Biren.

Since most legal disputes involve multiple categories of damages, allocating damages can lower your tax liability as the plaintiff.

“When drafting a settlement agreement, it’s usually best practice for the plaintiff and defendant to agree on what is paid in its tax treatment. Although the tax terms in settlement agreements are not binding on the IRS or the courts, they are often followed and rarely disregarded,” Mkrtchyan says. “Work to agree on a tax treatment and divide up the total settlement amount, allocating it across multiple categories, many of which can be non-taxable.”

Another tactic is to treat the settlement as a recovery of basis or identify possible capital gains rather than ordinary income.

“If your suit is about damages to your capital asset – such as your house or business – the proceeding settlement may be treated as a reduction rather than a gain. If a reduction is not an option, such suits may also be treated as a capital gain,” adds Mkrtchyan. “Long-term capital gain is taxed at a lower rate, 15% or 20%, and is therefore much better than how ordinary income is taxed.”