Lawsuit Settlement Taxes: The Basics

Are Lawsuit Settlements Subject to Taxes?

Generally speaking, the I.R.S. does not tax suits filed to recover damages for personal injury, sickness, or death. In most cases, whether a settlement is taxable depends on the type of damages you recovered in exchange for your release of claims.
Personal Injury and Physical Sickness Damages
The I.R.S. does recognize that personal injuries are not taxable. Among the small group of exceptions, physical sickness is one of those circumstances. The key in this case is that your personal injury must have caused you to suffer physical illness in order for your case to avoid taxation. Your physical injury must have been the result of some release of a claim.
If part of your settlement included compensation for lost wages and/or income, you will need to report this amount as income on your return. This is true even if the amount itself represents wages from when you were disabled from an accident you intend to sue about.
Physical Sickness Damages
If you are recovering damages for having been physically sick, you do not have to worry about paying taxes on the amount you receive in settlement. Even if you were not to file suit, you would not need to pay taxes on a recovery for damages to your own health.
Emotional Distress (Mental Anguish)
You will not have to pay taxes on damages that recover a physical illness or sickness . However, the rules are a little different for damages received for emotional distress (mental anguish). The I.R.S. says it will tax any damages you receive for emotional distress if any if you did not suffer a physical illness and if the only reason you saw a doctor was to help you cope with your emotional distress.
Remember that none of this applies to emotional distress damages received in connection with a physical injury, such as loss of enjoyment of life or bystander liability settlements.
Punitive Damages
In August 2014, the U.S. federal government established a law to tax the receipt of punitive damages. These taxes apply where a lawsuit for a physical or non-physical injury is deemed primarily punitive or a punitive element is added to damages for physical injuries. Punitive damages are defined by the I.R.S. as compensation awarded in a civil suit or punctuated criminal case that is intended to punish a suspect as well as to warn others.
Where your lawsuit depended more on punitive than compensatory damages, you may find yourself with a surprising taxable settlement. In these situations, you may be able to get away with paying less or nothing at all, although these cases will vary widely on the facts presented. To be informed try to ask someone knowledgeable about the law, including one of the attorneys on this site.

Types of Lawsuit Settlements

The Internal Revenue Service treats different types of lawsuit settlements differently when assessing taxability. While most settlements are considered ordinary income, the tax treatment can be affected by the nature of the settlement. As a general rule, nontaxable payments are intended to compensate an injured party for tangible and intangible harms.
Payments intended to compensate for physical injuries or physical sickness are nontaxable, based on Internal Revenue Code Sections 104(a)(2) and 213. While there are no bright-line rules, the IRS generally deems damages awarded in connection with a physical injury or physical sickness to be nontaxable if those damages arise out of: (1) the impairment of a physical function; (2) pain and suffering caused by a physical injury; (3) disfigurement or scarring; or (4) mental distress caused by a physical injury.
Payments for personal physical injuries, mental distress, turn on the intention of the parties and the documentation that they provide to the IRS. For example, if a defendant admits to physical injury or physical sickness in a statement to the IRS, then the payment receipt is likely to be treated as nontaxable. However, if neither the defendant nor the plaintiff allocates the payments to a particular claim, whether the payments are taxable is unclear.
If a plaintiff cannot properly allocate payments based on the settlement documentation provided to the IRS, the IRS will review the "totality of the facts" and determine if the damages were intended to compensate for a physical injury or physical sickness. To avoid potential taxable damages, defendants should take care to include a clause in the settlement documents stating that the damages were awarded for physical damages, as that clause could, at least in the IRS’s eyes, show the intent of the parties.
Payments for emotional distress and non-physical injuries are generally considered taxable income under the Internal Revenue Code Section 104. However, damages awarded as compensation for emotional distress and non-physical injuries are generally nontaxable if: (1) the emotional distress damages are associated with a physical injury or physical sickness; or (2) the emotional distress is itself triggered by a physical injury or physical sickness.

Taxation of Personal Injury Settlements

Lawsuit settlements related to personal injury are given special importance due to the complex nature of personal injury claims. For most other personal injury claims, it had long been considered that the damages received were subject to income tax. This was due to the IRC (Internal Revenue Code) Section 104(a)(2). This income tax treatment was further complicated by tax court decisions over the years, which left many trial lawyers and clients unsure of how to properly report them. The IRS respected these tax court rulings but every so often a new ruling changed the rules.
Under the full weight of the new federal tax reform law passed by Congress in December 2017, there have been some changes. It is important to know how these recent changes may affect you.
In general personal injury payments for physical injury or physical sickness are not considered gross income. This means the injured party does not have to pay taxes on the amount received as part of the lawsuit settlement. However, sometimes it is not obvious whether or not the settlement will be subject to federal income taxes. These concerns usually arise in cases involving the following:
There is one case of note where a taxpayer was awarded a settlement for punitive damages in an attempt to punish the defendant for wrongdoing. While the punitive damages were included in the lawsuit, the Tax Court ruled that it was subject to income tax while the compensatory damages were not.

How Emotional Distress Settlements are Taxed

The Internal Revenue Service has ruled that damages for physical injuries and death are not included in taxable income. The Tax Code excludes from gross income damages for physical injury or physical sickness, but mental or emotional distress are part of the normal human condition. Physical injuries are treated differently from mental and emotional distress. Thus, unless the damages for emotional distress are related to a tax free physical injury, they will be subject to income tax.
To establish that there is a sufficient connection between the damages for emotional distress and the physical injury, the taxpayer must prove that the damages for emotional distress relate to the physical injury. Courts have determined that damages for emotional distress experienced while in a coma for over a year were excludable from income. In this case, 2 years after being injured and placed in an induced coma, the plaintiff began to experience post traumatic stress syndrome, and such emotional distress was allowed to be excluded from income.
However, in the case of Blalock v. Commissioner, the Tax Court determined that emotional distress from handicap discrimination was not excludable from income. Mr. Blalock was diagnosed with fibromyalgia following a car accident in 1986 and thereafter suffered chronic pain, anxiety, and emotional distress. He settled his disability claim with the city and received compensation for his emotional distress. The city did not award damages for a physical injury, which would have been tax free under the Tax Code. The Tax Court held that while damages for emotional distress would otherwise not be included in income, since this settlement did not arise from a physical injury, it was included in income.

Tax Treatment of Lost Wages Settlements

The IRS does consider wages lost due to an injury as income, and thus subject to taxation. The IRS Publication 957 makes it clear that the IRS considers any income as wages or salary, no matter how the payment is actually made. In other words, the IRS views it simply as wages. So, if you receive a settlement for lost wages, the IRS will view it as income and tax you. You will be treated the same as if you received a paycheck from an employer. While your workers’ compensation attorney will not see much of that money, he or she will advise the IRS that the money was paid to you, making you liable for the taxes. The reason the IRS treats this issue so strictly is due to the fact that most people pay their taxes from their paycheck. If the IRS began treating settlements as something other than wages, with it went the ability to collect that money owed.
A great example of this same idea is the recent case of Money v. United States. Here, an employer and an employee entered into a settlement agreement, with the employee receiving $7 , 500 paid in four installments. The keyboard "final payment" allowed the employee to sign off that no further action would be taken in a lawsuit against the employer, and the employee would report the payments as wages on his taxes. In reality, the employee considered the settlement as a gift and did not treat it as subject to federal income tax. After data matching the information the employer gave to the IRS, the IRS determined that the employee had not reported the income, owed back taxes, and even charged the employee with a penalty for under-reporting his income. The employee believed that the funds he received from the settlement were a gift, and not wages, so he did not report them as wages. His defense was that the key word "final payment" and that calling the payment a "settlement", rather than wages (as required by the IRS), as well as the fact that it was paid in four installments. The IRS denied the claim, stating that the settlement was paid in order to stop a lawsuit. While the lawsuit may have been for various things, the bottom line is it was about wages.

Punitive Damages Settlements and Taxes

Punitive damages are generally required to be included in a taxpayer’s gross income to the same extent and in the same manner as similar items of gain. Where a receipt is characterized as punitive under state law but, would not otherwise be subject to Federal tax, such as in a personal injury case or a lost profit lawsuits when the jury’s purpose in awarding the punitive damages was to punish (as opposed to compensate), the punitive damages are taxable.
It is important to understand that punitive damages are a separate component of an award or settlement. The characterization of whether a recovery is a settlement or a judgment does not affect the characterization of any component parts. When the parties resolve the punitive damage aspect of a lawsuit by a settlement agreement and the court must still decide the amount of damages, the court’s decision will not determine the tax consequences because the parties’ settlement agreement (unless the agreement is silent) establishes the tax treatment of each aspect and component of their settlement.
There are several situations in which punitive damages will not be taxable. As noted above, where the punitive damages are awarded in a personal physical injury lawsuit, but awarded for something other than "physical injuries" such as loss of enjoyment of life, inconvenience, mental distress, pain and suffering, then such amount is excludable from income.
However, if punitive damages are awarded by the jury in an action for wrongful termination, then the punitive damages will be taxable. The loss of employment is not a physical injury, therefore, the punitive damages are not excludable.

How to Figure Out if Your Settlement is Taxable

In order to assess and calculate their potential tax liability, individuals with lawsuit settlements should follow this simple process:
Make an overview of your income sources, both those related and unrelated to your lawsuit settlement;
Determine the nature of the damages awarded in the court;
Differentiate damages according to their tax status;
Use tax and accounting expert advice as necessary for a suitable evaluation of your case.
Taxable damages normally include compensation for the following:
Loss of wages;
Punitive damage awards;
Interest on a settlement;
Property damage;
Permanent injuries;
Physical and mental distress.
Non-taxable damages; that may be awarded are damages for:
Property damage;
Physical injuries;
Emotional distress awards;
Wrongful death of a spouse, regardless of whether the harm is physical or emotional;
Profits from sale of property used in the trade or business as part of a divorce action;
Damages for loss of future earnings provided in a divorce settlement;
A settlement payment under a discrimination law suit.
If aspects of the suit cover multiple areas (for example emotional distress as well as medical expenses), the different elements could be taxed at various rates. In these situations, IRS regulations state that a portion of the award that is a physical injury should be separated or allocated from the damages for non-physical injuries. To simplify this division, the IRS allows for a pro-rata division, a simple comparison of the total awards to the physical injury and emotional distress damages. However, higher rates of accuracy can be used if you account for the guidance given by well-informed tax advisors and accountants.

Talk to a Tax Professional

Because the tax consequences that apply to lawsuit settlements vary widely, the resolution of a lawsuit can create complex tax issues. The last thing you want is for the IRS to come knocking on your door because you didn’t set your taxes up properly to reflect your settlement . To avoid ending up in hot water with the IRS, be proactive about taxes on your lawsuit settlement by consulting with a tax professional. A tax professional can walk you through how the IRS expects you to handle your settlement.