Paying Taxes On A Lawsuit Settlement Explained
Updated June 2023
If you have been awarded settlement money as a result of winning a lawsuit, think twice before spending the entire reward until you know whether you have to pay taxes on the awarded funds.
The Internal Revenue Code states that all income is taxable unless it is a qualifying exemption, so depending on the settlement circumstances, failing to report this income could result in some serious consequences, such as the government accusing you of tax-evasion. Continue reading for advice about how to approach your lawsuit settlement taxes.
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Key Takeaways:
- According to tax law, all taxpayer income, including settlement money, is considered taxable unless it is considered one of the exceptions in the Internal Revenue Code, such as cases involving physical injury.
- Lawsuit settlement payouts are usually considered taxable when the case does not involve physical injury and can include proceeds related to emotional distress, punitive damage, interest, and lost wages.
- Lawsuit settlement proceeds are usually considered nontaxable when the case involves physical injury and can include emotional distress related to the injuries, sickness, and medical expenses.
- Depending on the specific circumstances of the settlement, taxpayers may have to report their settlement income as personal income using an IRS W-2 form, 1099-MISC form, or 1099-INT form.
Taxes On Settlements
You might wonder: do I have to pay taxes on lawsuit settlements? That depends. While you may have felt a rush of initial excitement about being awarded a large sum of money, the unfortunate truth is that depending on the type of lawsuit settlement, some or all of the settlement funds could be considered taxable income.
This situation can become difficult when taxpayers are unaware that they owe taxes on the settlement amount until they receive a 1099 Form in the mail during the tax season and aren’t prepared to pay their tax bill.
What Is A Lawsuit Settlement?
A lawsuit settlement describes a resolution of a legal case between conflicting parties, which can be reached either before or after the commencement of court proceedings. In the case that a lawsuit settlement agreement results in one party being awarded a settlement payment, these funds may be subject to taxation.
Taxable Settlement Award Examples
Non-Physical Lawsuit Settlements
Proceeds earned from lawsuits involving non-physical cases are typically considered taxable income.
Emotional Distress
Individuals suffering from emotional distress related to a lawsuit that does not involve physical injury may receive a settlement payment that is considered taxable income. These cases could be related to defamation, sexual harassment, or wrongful termination.
Punitive Damages
Punitive damages are funds that are paid in a situation when a defendant was grossly negligent, malicious, or reckless, as a way to punish the defendant rather than compensate the victim. These damages are always taxable.
Interest
Any interest on settlement money that accrued either pre-judgment or post-judgment is considered taxable. The amount of interest that builds on settlement awards can vary depending on whether plaintiffs schedule a structured settlement payout or if a plaintiff requires a lump sum payment.
For example, if accepting a settlement payment results in the taxpayer being pushed into a higher tax bracket, any earnings falling above a certain threshold will be taxed at a higher tax rate.
Lost Wages or Back Pay
Due to the fact that wages are usually subject to income taxes when received without interruption, lost wages are also considered taxable during settlement negotiations.
Nontaxable Settlement Award Examples
Below are some examples of lawsuit settlements that could be considered tax-exemptions.
Physical Injury Lawsuit Settlements
Proceeds awarded during personal injury claims are usually tax-free. A payout could be awarded as compensation for car accidents, wrongful death lawsuits, medical expenses, and lost wages.
Emotional Distress
When individuals are emotionally distressed as a result of a physical injury, the settlement award for these damages can be considered nontaxable settlement payments.
Medical Expenses
Settlement proceeds related to medical expenses are considered tax-exempt unless the funds were already claimed as tax-deductible on their federal income tax return.
Physical Illness
Getting physically sick as a result of a lawsuit, such as being exposed to chemicals, may result in a nontaxable settlement.
How To Report Lawsuit Settlement Income To The IRS
Reporting lawsuit settlement income to the IRS involves understanding the tax-related circumstances of the lawsuit, gathering documentation related to the case, such as bills and receipts, and submitting the appropriate tax forms to the IRS.
Tax Forms
If you have been awarded settlement proceeds upon winning a lawsuit, you may have to file certain tax forms to report those earnings to the IRS as personal income.
Tax Form 1099-MISC
When an insurance company pays a settlement award to people who have won a lawsuit, they will send out a 1099-MISC tax form during the tax season that describes the settlement payout. Taxpayers who receive this tax form can follow the instructions to report the settlement money as miscellaneous personal income so they can pay the portion of tax fees they owe.
Tax Form 1099-INT
Taxpayers who have received pre-judgment or post-judgment interest during a settlement case may receive a 1099-INT tax form to submit when they file their taxes.
Tax Form W-2
In employee-related lawsuits in which employees are awarded compensation for lost wages, such as in the form of front pay, back pay, or severance pay, they may report these earnings in a W-2 tax form.
Tax Professionals Can Help
If you are experiencing any level of uncertainty related to your settlement earnings and whether or not they are tax-advantaged, hiring a tax accountant or tax lawyer for tax advice can be a monumental asset in lowering your tax liability.
Tax professionals can help you understand how much you owe in taxes, determine which tax forms you are required to submit, and can guide you throughout the tax return preparation process to ensure your tax planning is seamless and stress-free. Even though it costs money to hire a tax attorney, being saved from the headaches of figuring out your tax responsibility and the security of knowing your tax situation is handled correctly is priceless.
If you have been involved in a lawsuit that resulted in you being awarded a settlement payment, you must figure out the taxability of those earnings and your responsibility as a taxpayer to report those taxes to the Internal Revenue Service.
Understanding what to do during settlement situations is simple when you consult with an expert at Ideal Tax. We specialize in tax relief and various IRS programs available to citizens. So, if you are ready to start, schedule a free consultation with us today.
Luis serves as the Director of Operations for Ideal Tax, overseeing a multifaceted team including case management, tax professionals, document specialists, customer support, training, and development.
