You Got a Personal Injury Settlement. Does the IRS Feel Your Pain?

When it comes to legal settlements, there are careful and creative ways to structure your settlement and payout so as to maximize the amount that will be exempt from taxation. iQoncept/Shutterstock

You got a check from a legal settlement—perhaps from a personal injury lawsuit, a wrongful termination case, or a vehicle accident. You got a settlement from your insurance company, or an exit check from your former employer. Are those payouts taxable?

The general rule regarding taxability of amounts received from the settlement of lawsuits and other legal remedies is Internal Revenue Code (IRC) Section 61. This section states that all income is taxable regardless of its source, unless exempted by another section of the code.

Taxable income, therefore, can include part or all of legal settlements.

There are exceptions. The federal government does not tax settlement money in cases where the judgment amount received is intended to compensate you for measurable losses that you sustained. This applies to actual economic damages (for example medical bills or lost wages).

Another exception applies to some non-economic damages such as pain and suffering and emotional distress.

The facts and circumstances of your case make a difference in whether the proceeds are considered by the IRS as income—and taxed—or are exempt. A tax attorney or tax accountant can help you identify those exceptions.

Settlements: Categories Exempt From Federal Tax

Actual damages, including lost wages from both physical injury and sickness, as well as money received from workers’ compensation, are generally exempt from taxation.

Emotional distress damages related to physical injury are tax exempt if the emotional distress is caused by a personal physical injury or physical sickness.

However, the converse does not apply: if the emotional distress causes a physical illness—for instance, anxiety that leads to an ulcer or insomnia—damages related to that emotional distress are taxable.

And if the emotional distress is completely unrelated to a physical injury or sickness, the damages are taxable, although the taxable amount may be reduced by certain medical expenses.

Punitive Damages: Taxable

Punitive damages are generally taxable. Punitive damages that are awarded in lawsuits are intended to punish the defendant rather than simply compensate the plaintiff for losses.Unlike compensatory damages, which aim to restore financial losses suffered by the plaintiff, punitive damages serve as a deterrent to prevent similar conduct in the future.

The downside of that is that the plaintiff owes taxes on damages received.

If you’re a plaintiff, you can no longer deduct personal legal fees when filing taxes, due to the Tax Cuts and Jobs Act of 2017, although business legal fees are still deductible. Plaintiffs may be taxed on the total punitive damages amount, even if a large portion of that amount goes to their attorney, and even if the defendant pays your attorney directly.

Job-Related Lawsuits: Taxable

Damages from employment-related lawsuits are generally taxable. An example would be wrongful termination. Generally, settlements for lost wages, severance pay, back pay, and front pay in employment-related lawsuits are taxable and subject to Social Security and Medicare taxes.

Dismissal, severance, or other payments for involuntary termination of employment are also all taxable.

Contractual and punitive awards from lawsuits for discrimination—whether it’s age, race, religion, gender, or disability—are also taxable.

If you win a judgment in an employment-related lawsuit for unlawful discrimination, or for involuntary termination, that portion of the proceeds defined as lost wages (examples are severance pay and back pay) is not only taxable but also subject to Social Security and Medicare taxes.

These proceeds are subject to employment tax withholding and reported as Wages, salaries, tips, etc.” on line 1 of Form 1040.

Job-related Lawsuits: Non-taxable, Sometimes

When it comes to employment-related lawsuits, settlements for physical injuries or physical illness are not taxable, unless you previously deducted medical expenses related to the injury.

If the settlement includes damages for emotional distress or mental anguish, the tax treatment depends on whether the distress stems from a physical injury.

As noted above, if the emotional distress stems from a physical injury, it’s treated as a physical injury settlement and is not taxable. If it does not, it is taxable, though you may be able to reduce the taxable amount by deducting related medical expenses.

Vehicle Accidents: Mostly Non-Taxable

Most settlements from vehicle accidents are not taxable.

A settlement related to property damage is not taxable, unless the amount you’re awarded is more than the property’s net cost. In that case, you'll owe taxes on the excess amount.

However, the factors already mentioned—type of injury, and whether the settlement is punitive or compensatory—can affect whether part of your settlement is taxable.

Be Proactive

There are careful and creative ways to structure your settlement and payout to maximize the amount that will be exempt from taxation.

It’s best to consult a tax attorney or tax accountant before accepting any settlement. Personal injury attorneys specialize in this area of law. They can make sure any settlement amount and payment agreement are structured to benefit you to the greatest extent possible.

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