Winning a settlement in a personal injury case, divorce settlement, or civil suit can help you get back on your feet and compensate you for the harm you suffered. You can use your settlement to pay medical bills and other case-related expenses and support yourself while you recover or rebuild your life.
You may wonder, “ are settlements taxable”? when you win a large sum following a legal or civil case. Learn what portions of your settlement may be tax-free, which parts you may owe taxes on, and how to minimize tax liability on your compensation.
Understanding “ are settlements taxable ” requires knowing what the IRS considers ordinary income and how it is taxed regarding settlements. The IRS states in Section 61 of the Internal Revenue Code (IRC) that all income is taxable unless it qualifies for exemption under another section of the IRC, regardless of the source of the income.
Income from settlements, awards, and lawsuits is taxable unless it meets one of the specific exclusions in IRC Section 104 .
To determine if income from a lawsuit settlement qualifies as non-taxable, the IRS will consider the facts and circumstances of each settlement payment. The IRS considers proceeds from most lawsuit settlements to be income, which is taxable under IRC Section 61.
The most commonly-cited exception is personal injury settlements, which are typically non-taxable. Certain emotional distress settlements that involve actual damage are also considered non-taxable. Additionally, the IRS does not consider proceeds from insurance settlements to be income and will be non-taxable in most cases.
In many situations, the IRS will only tax a portion of the proceeds from a settlement. For example, in settlements involving emotional distress, the IRS may consider a percentage of the settlement as non-taxable if the plaintiff can prove that the distress involves physical injury.
Example: Jonah develops PTSD after a bad car accident. If he can prove that the negligent behavior of the other driver directly led to his development of the condition; the IRS may consider a portion of his settlement proceeds non-taxable, even if the source of his claim was his emotional distress.
Taxpayers may also be able to lower the taxes they owe on settlement proceeds. For example, if a plaintiff paid medical expenses related to emotional distress in prior years but did not deduct the payments on their tax return, they will pay less taxable settlement proceeds.
Learn how the IRS tax proceeds in legal settlements, like back pay, payment for personal injury, and punitive damages.
In employee-related lawsuits, such as involuntary termination or unlawful discrimination suits, employees who win their cases may receive compensation for lost wages in the form of back pay, front pay, or severance pay.
In employment-related lawsuits , the IRS considers the portion of your proceeds to cover your lost wages taxable. As a form of compensation for lost wages, you must pay taxes on back pay and report it as income on your tax return .
Example: Abe is awarded $10,000 in the form of back pay after a successful unlawful discrimination lawsuit. Since the IRS considers back pay settlement proceeds as wages, Abe must report it as ordinary income and pay taxes on the back pay. His employer should send him a W-2 that reflects withholding federal and state (if applicable) taxes as well as FICA taxes.
If you are injured or sick, you may receive a settlement to help compensate for lost wages and pay medical bills.
If you did not deduct medical payments related to your injury or sickness in previous tax years, the full amount of your settlement is non-taxable . You should not include proceeds from the settlement on your tax return.
If you did deduct medical payments in prior tax years, you need to include the portion of the settlement you deducted for these payments as income to the extent that these deductions offered tax benefits.
If you made these payments over multiple years, part of the proceeds for your medical bills must be allocated on a pro-rata basis to each of the years you made medical payments, as detailed in IRS Publication 525 . These taxpayers should report the tax benefit amount on Form 1040, Schedule 1 , under “Other Income.”
Example: Bella was injured at work and received a settlement of $50,000. Since her injury was sudden rather than chronic, she has not deducted any medical payments for the injury in prior tax years. Bella’s settlement is non-taxable if the entire award goes towards medical care, such as hospital treatment, physical therapy, and medication to treat the injury.
You may also receive proceeds from a settlement to compensate for emotional distress or mental anguish. If these proceeds are attributable to sickness or personal injury, the IRS will consider them non-taxable, like settlements involving personal injury. Settlements earmarked for medical expenses that stem from emotional injuries won’t be taxed.
If the proceeds you receive in an emotional distress settlement cannot be attributed to physical sickness or injury, they are considered taxable, and you must include the proceeds in your income. The amount of these proceeds you must include in your income can be reduced by:
You can calculate the taxable proceeds from emotional distress settlements unrelated to physical injury using this calculation:
Entire settlement amount – (related medical costs not previously deducted) – (deducted medical costs with no tax benefit) = taxable proceeds
Example: Cole received $50,000 in proceeds as a settlement in an emotional distress lawsuit. Cole has been feeling mental anguish and has paid $10,000 in medical expenses in the last few years, none of which he has deducted from his income.
Since Cole’s emotional distress settlement payments are unrelated to physical illness, all the proceeds from the settlement are taxable except for his non-deducted medical payments related to his distress ($10,000). Cole must only pay taxes on $40,000 of the settlement proceeds. He should report the net taxable amount on Form 1040, Schedule 1, under “Other Income.”
Punitive damages are payments a guilty defendant must make on top of paying any compensatory damages. Punitive damages are typically awarded when the compensation to the injured party is deemed insufficient or to punish the defendant for grossly negligent or intentional criminal behavior.
Because punitive damages aim to deter further criminal behavior and set an example for others, punitive damages can be quite high. The amount an individual must pay in punitive damages will depend on the nature of their behavior and state.
Some states cap the amount of punitive damage. For example, Alabama statute limits punitive damages to $500,000 or up to three times the compensatory damage owed. Other states, such as Arizona and Iowa, have not set a cap on punitive damages. Arizona even has a law prohibiting the establishment of a damage cap in cases involving wrongful death or personal injury.
Many states fall somewhere in the middle. In Louisiana, punitive damages are allowable in circumstances involving drunk driving, criminal sexual activity with minors, and toxic waste disposal, but not in most other situations. As stated in IRS Publication 4345, punitive damages are always taxable , even those received in a settlement for physical sickness or injury. Taxpayers should report these damages as “Other Income” on Schedule 1 of Form 1040.
Example: Dana gets drunk at a party but decides to drive home anyway, despite having multiple DUIs on her record. While driving in her home state of Virginia, she strikes a law-abiding pedestrian. While investigating the accident, it is determined that Dana’s BAC is 0.3. Under Section 8.01-44.5 of the Virginia state law code , any driver with a BAC of over 0.8 can legally be awarded punitive damages in a settlement.
The court will consider Dana’s actions and prior DUIs to determine the punitive damages she owes. This amount cannot be over $350,000 , the Virginia cap on punitive damages.
When a settlement is awarded to a recipient, the at-fault party must pay proceeds to the damaged party. These proceeds often come with interest, which is considered taxable .
There are two types of interest involved in settlements: pre-judgment interest and post-judgment interest.
Pre-judgment interest accrues between the time when the injury or damage occurred and the time of the legal judgment. Post-judgment interest accrues between the time of the legal tax judgment and when the settlement is paid.
Keep in mind that even if you win a settlement, you may not see the proceeds for several weeks, months, or years, depending on the complexity of your case. For this reason, some plaintiffs prefer a structured settlement payout that allows interest to accrue on their proceeds over time, leading to a higher total payout.
Other plaintiffs choose (or require) the security of a lump-sum payment. Although lump-sum payments do not have time to gain value in interest, the payout is more immediate.
You must work with your lawyer to determine your pre-judgment interest rate. Your state will set its interest rate for your settlement, which accrues until you receive the money. For example, the pre-judgment interest rate in California is 10% , and in Colorado, it is 9%, compounded annually .
Similarly, you must work with your attorney to understand the post-judgment interest rate for your settlement, as each jurisdiction varies per state and timeframe. For example, the California rate for post-judgment settlements is 3.91% beginning on September 16, 2022, and the Kansas rate was 4.25% from July 1, 2021, to June 30, 2022. Judgments will have post-judgment interest from the date of the judgment until the settlement proceeds are paid .
The US court system has statutes governing the three categories of legal judgments, which further detail the nuances of interest rates in specific proceedings.
Both pre-judgment and post-judgment interest are taxable to the recipient. Taxpayers can report this interest as “Interest Income” on line 2b of IRS Form 1040.
Example: Ed wins $200,000 in a personal injury settlement after being injured in a car crash that was not his fault. Ed is comfortable financially, so he agrees to a structured settlement in which the at-fault driver agrees to pay a portion of the compensatory damages each month for five years.
Ed took the deferred payment option to accrue interest on the settlement, but the total amount will vary depending on your state and fees. Most states have default rates for settlements, but these can be changed to agreed-upon amounts regarding the contract signed.
The rates can also vary depending on if they are pre- or post-judgment, as well as when the contract or state law determines which rate will be used. Ed is happy with this situation because he knows post-judgment interest will accrue on the unpaid balance of the judgment.
We will represent you or your business before the IRS in an event of an audit.
Most of the time, the IRS considers proceeds from legal settlements to be income. As stated in IRS Publication 525 , proceeds from legal settlements are considered taxable income unless they meet a specific IRS exemption. Most of the specific IRS exemptions pertain to settlements from personal injury cases, which the IRS considers non-taxable. Taxpayers must report all taxable income on their yearly tax return.
To determine whether a settlement is taxable, you first need to understand how the IRS categorizes legal claims.
For tax purposes, the IRS divides legal settlements and awards into two categories: claims from physical injury and non-physical injury. Within each category, claims can be further divided into:
It is important to remember that your claim is your cause of action, the reason behind your lawsuit. If you are seeking compensation for actual damages like a physical injury or property damage, your settlement will receive different tax treatment than settlements for emotional distress without physical damage. Whether or not your legal settlement is taxable depends on how the IRS categorizes your claim.
Most settlements in which physical damage occurs are non-taxable, but the IRS will tax the following in most cases:
The IRS differentiates between so-called “actual damage” and emotional distress for tax purposes. Most settlement cases that don’t involve clear physical damage, whether to another person or their property, are taxable.
With regard to emotional distress settlements and taxation, the IRS requires payment on some forms of emotional distress while not on others. According to IRS Publication 4345 , if your emotional distress, defined as an adverse emotional response to an event , is the result of your physical injury, your settlement isn’t taxable.
The funds are taxable as other income if you receive compensation for emotional distress not caused by injury or sickness. This situation may include emotional anguish resulting from witnessing a traumatic event or suffering non-physical discrimination or humiliation. You can reduce your tax liability in this case by subtracting the cost of medical bills you paid and did not deduct.
The following settlements tend to involve emotional distress:
Proceeds from emotional distress settlements are non-taxable if they can be attributed to personal physical sickness or injury . If there is no clear personal or property damage involved, the IRS taxes proceeds from settlements involving emotional distress in most cases.
Remember that even if the IRS considers the proceeds from your settlement to be taxable income, you may still be able to reduce the taxes you owe. You can reduce both payments you have made for medical expenses related to your emotional distress (i.e., to a therapist) and medical payments that you have deducted previously but that did not offer a tax benefit.
For an emotional distress case to be non-taxable, the plaintiff must prove that the defendant’s actions led to physical illness or injury. If there’s no form of physical injury or property damage, the settlement will be taxable in most cases. The question is: where is the line between emotional distress and personal injury?
Differentiating between physical and emotional damage can get confusing since emotional distress often comes with physical symptoms like insomnia, stomach disorders, and headaches. The key to understanding the difference is to look at the cause or root source of the physical sickness.
In most instances, if your emotional distress leads to physical sickness, the IRS will consider your settlement taxable because your emotional distress caused your illness, not the defendant’s action. On the other hand, if your claim that a defendant’s actions caused you to get sick is successful, your settlement (or a percentage of it) is non-taxable in most cases.
The following real-life example shows how one woman received a partially non-taxable settlement by proving that her employer’s actions led to her emotional distress.
Example: Domeny vs. Commissioner (2010)
In Domeny v. Commissioner , the plaintiff, Ms. Domeny suffered from multiple sclerosis (MS), a disabling nervous system disease. Ms. Domeny alleged that workplace problems (including an embezzling employer) worsened her symptoms in her case. When her doctor told her she was too sick to work, she was terminated, causing her MS symptoms to worsen. When Ms. Domeny was awarded a settlement for her employment case, a percentage of the proceeds were considered non-taxable because her employer’s actions caused her condition to worsen.
As the example illustrates, receiving a non-taxable or partially non-taxable settlement in an emotional distress case is possible.
The situation becomes even more complicated in cases involving sexual abuse and harassment. As of December 2017, the IRS prevents tax deductions for sexual abuse and sexual harassment settlements subject to nondisclosure agreements.
Many taxpayers are clamoring for clarification on the taxability of sexual abuse and harassment settlements. It is both sensitive and complicated to differentiate between physical and emotional damage when sexual abuse is involved. Many more believe sexual abuse should qualify as personal injury and that the IRS shows inconsistent behavior by taxing sexual abuse settlement proceeds but not proceeds from, say, a slip-and-fall accident.
