After a long-fought battle, you finally get the compensation you deserve for your damages. While you think there is nothing else you need to do besides separate the money and use it for your expenses, there is a question that many personal injury victims still have, which is whether a settlement is taxable.
The IRS collects taxes on any income that you receive. Depending on the details of your settlement offer, you will need to speak with an accountant or other financial expert to determine how you should proceed with your taxes and money management after a settlement.
When a settlement offer reaches six or seven figures, you need professional help.
After a lawsuit, money and damages are income that the IRS can tax. However, if yours was a personal injury settlement, then your award is nontaxable. Most often, nontaxable personal injury lawsuits are car accident claims and slip and falls.
Exceptions may apply to taxable and nontaxable settlements, as every case is unique. There are instances where only part of your settlement is nontaxable, and the other is taxable.
When you finalize your settlement with a lawyer, ask what you should do next. While a personal injury lawyer can provide general advice, it is best to work with a financial expert once you get advice from your lawyer.
For a settlement to be taxable, it must be income or a form of income under the IRS definition. The IRS deems all money from any source as income. Legal settlements are a bit of a gray area since some cases are nontaxable and others are taxable. There are even certain settlements that will have a bit of both taxable and nontaxable income. It is essential to know which parts of your settlement are income and which are not, so you do not pay taxes on the wrong ones.
Lost wages: When an accident leaves you unable to work, you must include your lost wages and other employment benefits in your demand. Remember, these benefits are the income you will make if you had not suffered an injury from an accident. Since you will have paid taxes if you can still work, any compensation you receive replacing that income is taxable. The lost wage benefits you obtain will also be subject to Medicare and social security taxes.
Punitive damages: Most cases will not result in punitive damages. Many times, punitive damage awards are taxable. The primary instance where punitive damages are nontaxable is in wrongful death cases, but other exceptions may apply.
The most common taxable situations include:
- Interest in compensatory awards
- Title VII damages
- Pension rights damage awards
- Patent, copyright infringement, or breach of contract awards
- Any attorney fees or legal costs outlined in the settlement award
The IRS considers most of these awards income and therefore taxes them.
- Physical injury: When there is apparent physical harm, the IRS does not tax the settlement award. The IRS understands that the bodily harm is not your fault and that the compensation you receive is to compensate for the physical injury, not for any other purpose. You will not need to include bodily harm payment in your tax filing.
- Car accidents: While personal injury covers various topics, the most common are car accidents. Most of these cases and funds are nontaxable and therefore not income. The contingency fee that the attorney works off of can be taxable in some cases, but the majority are not. You will not need to include these settlement amounts in your taxes unless your case meets a particular exception.
- Medical expenses: Under the tax benefit rule, if you file an itemized deduction and include medical expenses for prior years that are directly related to your accident, you must include this in your taxes. If you did not receive any reimbursement for medical expenses in previous years, then you do not include the income in your taxes. You need to have the payment in the “Other Income” section of the 1040 form.
- Vehicle damage: Property damage is typical in car accident claims. Since the defendant is offering payment as a reimbursement, then it is nontaxable. Even if your car is not a total loss, repair costs will also be nontaxable. Rental expenses are also part of this category.
- Emotional distress: You will not assume that emotional distress is a taxable payment, but it can sometimes be. When the emotional distress or mental anguish directly results from physical injury or harm from the accident, the damages are nontaxable and are not income. If you receive reimbursement in any previous years for emotional distress treatment, you will need to include these damages in your taxes. When the emotional distress did not result from the accident, it is taxable. There are many exceptions and other rules the IRS has in place for these instances. Speak with your lawyer if you are unsure what to do after settling.
What you need to file taxes?
Determining whether or not your settlement is income will be step one in whether you need to include it in your taxes. You can sit with your attorney and review how the documents were processed and filed in court.
Even if you are not filing taxes right away, you need to have an idea of what, if any, portion of your settlement is income and taxable. Keep all settlement documents in a safe space until it is time to file your taxes.
The key factors to consider when reviewing your payment award are:
- Was the payment filed as income
- Was the payment filed as wages
- Do you have a 1099 or W-2 for the settlement
- How much did you pay in legal fees
- Was it a full settlement check, or will you receive periodic payments?
Some cases will have two different claims against the same defendant. For example, you may file a personal injury lawsuit against the defendant and another non-personal injury claim. Upon settling, you will receive documentation outlining how the payor files each award and how much the award is for. The personal injury award you receive is nontaxable, but the other portion is taxable. It is vital to separate the two amounts because personal injury awards are often much higher than any other.
You do not want to include a settlement amount that is much higher and end up paying more taxes than you should. When you pay more than you owe, you will miss out on the money you need for necessary medical treatments and other items. Make sure to call your lawyer to ensure you have the proper documentation and an idea of what you must do during the tax session.
What are damage awards?
There are many different compensatory damages you can obtain from a lawsuit. The award you receive will vary by the type of case you file. Personal injury cases will have two categories of awards: economic and non-economic.
Under monetary damages, you will have tangible losses like medical expenses, property damage, and lost wages.
Non-economic damages will result in losses like pain and suffering, mental anguish, and loss of enjoyment of life. Non-economic damages are losses you obtain that are not tangible, meaning there is no receipt.
What determines taxability?
The IRS will look at several key factors to determine whether the settlement you receive is income and, therefore, taxable. When you look at your payment, you will need to break it down into categories to see which parts are income. Any awards for physical harm are not income and will not be taxable.
However, most lawsuit settlements will have various award types. While you must determine which part of your award is taxable and which is nontaxable, you must also break it down by category. Each category will have different tax concerns to consider as well.
The IRS will tax your total claim before your attorney takes their costs. Many victims don’t know this and can get into big trouble with the IRS if they do not claim the total amount. For example, if you receive a $100,000 settlement and your attorney takes $40,000, you will pay taxes on the $100,000, not the $60,000 you receive.
When you finalize the settlement, you must address the issue of a 1099 form. You will need to determine if you will get a 1099 form and how much of your award the form will show. You can negotiate the 1099 form to include only specific elements of the award, so income and taxable issues are easier to file.
Do not try to negotiate these terms on your own. Address these concerns with your lawyer or accountant.
During negotiations, you can also ask that specific settlement categories go in the nontaxable portion of your award. Some cases will allow you to allocate the funds as capital gains that are nontaxable and are not income. Capital gains are not available in all cases, but you can ask your lawyer if it applies to yours.
Your tax structure will differ when you decide to take periodic settlements instead of a lump sum. While you will still consider these payments as income, you will not need to pay the taxes on the entire amount in one year. You can spread out the tax duty over multiple years.
Obtaining a settlement for your pain and suffering from the negligent actions of another party can help you move on with your life. There are many nuances with settlement awards and whether they are income. The last thing victims concern themselves with is what tax obligation they can have from these settlements.
Do not go into settlement negotiations unprepared. Speak about the possibilities with your attorney and what you want to get out of the payment. Every case is different, and you need a personalized approach to your circumstances.
Legal Complexities for Settlements
It is important to note that a lawsuit settlement is an agreement between two parties to resolve a legal dispute. When the parties resolve the issue, the payment represents an exchange for the receiving party’s inability to take any other legal action against the defendant. A settlement shows that both parties believe the issue is final. Once a settlement amount is determined, the payment can take at least six weeks.
There are two ways a plaintiff can receive their settlement award. The first method is a one-time full settlement, the other as periodic payments. Both parties must agree to the payment structure before receiving any money.
Remember that in both payment options, you will have to work with your attorney to see which part is taxable, even if you are receiving structured settlements. A lawyer can advise you on what to expect, but you must meet with a financial expert to ensure you are doing the right thing financially.
There is one other factor to consider regarding settlements: confidentiality agreements. When there is a confidentiality clause within your settlement agreement, it can affect your tax liability. It will depend, however, on the specifics of the confidentiality agreement.
The IRS will tax the additional income if you obtain further compensation in exchange for confidentiality. The legal complexities of a confidentiality clause are vast, and you will need expert guidance in these matters.
A local personal injury attorney can guide you on how to proceed with your settlement. Your injury attorney can also advise you on the tax or financial expert you should consult after a settlement agreement.
Will my attorney tell me what to do about my settlement?
Yes, your local personal injury attorney can guide you on what portion of your settlement is taxable and which is not. They will also negotiate the specifics of your award categories and ensure you have the proper documentation for your taxes.
When you have a legal matter to address, you must call a lawyer in your area to discuss your options.