Are Lawsuit Settlements Considered Taxable Income?
When the attorneys at TheLawFirm.com settle a case, or receive a verdict from a jury, we are often asked whether the award is income for IRS tax purposes. Our clients are happy to hear that money received as compensation after a personal injury is generally not taxable by the Federal Government.
As always, please consider this general advice. Consulting with your tax attorney or CPA is wise. There are exceptions to almost every legal and tax-related rule. Furthermore, we are not familiar with your personal finances so we cannot offer specific advice. Your State may tax something the Federal government does not. Therefore, TheLawFirm.com recommends consulting with your financial advisor, tax attorney or CPA before you receive the money. This will help you know your tax burden, if any.
A personal injury settlement can be taxable, nontaxable, or partially taxable depending on the type of case and the type of compensation for injuries suffered. The taxable status of a personal injury settlement is often dependent on whether or not there was a "physical injury or physical sickness."
Physical injuries and physical sickness are generally non-taxable. For example, a client is injured by a metal on metal hip and has $100,000 in medical expenses. The maker of the metal on metal hip settles with our client for $100,000. The personal injury settlement will be tax-free and our client does not need to report it on a tax return. But, like most legal areas, there are exceptions. If, for example, our client deducted the $100,000 in medical expenses in a previous tax return, the settlement will likely be taxable.
A personal injury settlement with a monetary award based partially on emotional distress or mental anguish may be tax-free. If the emotional distress or mental anguish is directly related to a physical injury or physical sickness, it is considered "medical" and, therefore, non-taxable.
So, using the above example, our client again settles with the manufacturer of the metal on metal hip for $100,000. He receives $70,000 for his medical expenses due to extensive surgery. Our client also receives $30,000 in compensation for mental anguish for having to live in daily pain. Our client’s award of $30,000 for mental anguish would likely be non-taxable because it is directly related to his physical injury.
There are some monies however that are generally taxable. For example, the amount received in a personal injury settlement attributed to interest is generally taxable. Compensation received for emotional distress and mental anguish not directly related to physical injury or physical sickness is taxable. Defamation, invasion of privacy, discrimination, harassment, and wrongful termination would be examples of taxable money. Regardless of the type of case, punitive damages are generally taxable. Finally, a settlement award with compensation for lost wages or loss of income is taxable and must be reported on a tax return.
Besides talking to your tax advisor, a helpful document from the IRS on this issue can be found at https://www.irs.gov/pub/irs-pdf/p4345.pdf
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