Taxes on Lawsuit Settlements: Everything You Need to Know

After winning a lawsuit or settling one, many people are shocked to find out they have to pay taxes on what they've earned. Some people do not realize it until they get their IRS Form 1099 at tax time the following year. A little tax planning can go a long way, especially before you settle. 

Keep in mind that before you spend your settlement, it may be taxable income according to the IRS. Here's what you need to know about lawsuit settlement taxes.

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Do you have to pay taxes on lawsuit settlements?

Simple answer: yes. A large amount of money collected without at least informing the IRS is simply not legal. In many cases, they will ask for a share of the profits as well.

According to the tax code, the only damages that are tax-free are those resulting from physical injury or illness. In this case, you probably won't have to worry about the IRS wanting a portion of your cash.

In addition to compensating you for physical injury or illness, money damages may also be awarded for other reasons. Let's say, for instance, you won a discrimination lawsuit against your former employer. As a result of this, you receive back pay and compensation for emotional distress. This award is taxable at ordinary income rates since it does not relate to physical harm.

Punitive damages are another type of award, and they are meant to punish the defendant. Regardless of whether the underlying case resulted from an injury or illness, the damages are almost always taxable.

But the IRS may surprise you in another way. You may find yourself in a higher tax bracket if you receive a lump-sum payment. That means higher taxes.

You may benefit from hiring a tax accountant in the tax year that you receive your settlement, even if you normally do your taxes yourself online. It can be difficult to determine which parts of a lawsuit settlement are taxable by the IRS.

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How Taxes on Lawsuit Settlements Work

A lawsuit settlement's tax liability depends on the type of settlement. Damages from a physical injury are not taxable in general. You'll have to pay taxes on your damages, however, if you have already deducted medical expenses from your injury. You cannot get the same tax break twice.

Some non-physical suits may result in damages for physical injury. When someone wins a libel suit and gets damages for the doctors they saw about stress-induced headaches after being libeled, those damages are not taxable, assuming you haven't already deducted them from their taxes. Even though emotional distress damages are generally taxable, there is an exception if the emotional distress results from a physical injury or is manifested in physical symptoms for which you seek treatment.

Punitive damages, as well as back pay and interest on unpaid money, are typically taxable. Emotional distress damages are also taxable, but with the exceptions listed above. You owe taxes on the entire amount you receive, including any attorney fees. Even if you don't take the money home, it's still part of your award. In addition, if the opposing side has to pay your attorney's fee, that fee is also taxable. In certain types of lawsuits, you may be able to deduct your attorney fees.

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Taxable Lawsuit Settlements

Back Pay

Let's say you filed a lawsuit for back wages from a W-2 job. This would be considered ordinary income.

This means that you'll receive a W-2 for it, and income taxes and FICA taxes will both be withheld. Tax-wise, your settlement is pretty similar to a regular paycheck.

Consider it as income that should have been paid to you from the beginning. Therefore, you will pay taxes as if you had received the income during that time.

Punitive Damages

Punitive damages can be taxed if they are meant to punish a defendant for harmful behavior. This applies even if you receive them in a settlement for physical injury.

Settlement Interest

Interest on an unpaid settlement is called settlement interest.

As well as pre-judgment interest, which accrues between the time of the injury and the time of the judgment, you might see post-judgment interest as well. Post-judgment interest is payable between the time of judgment and the time of settlement payment.

Both types are taxable to the recipient.

Tax-Free Lawsuit Settlements

Personal Injury Settlements

Most of the time, the proceeds of a personal injury settlement are not taxed at all.

Tax-free compensation is available for both physical and mental injuries. Whenever a person experiences physical injury or illness due to another party's negligence, he or she is entitled to tax-free compensation for pain, suffering, and emotional distress.

Settlements for Medical Expenses

If settlement proceeds are designated for medical expenses, they won't be taxed. This is also true even if the proceeds are ultimately derived from emotional injury.

Pain and Suffering

A personal injury settlement in many states does not tax pain and suffering, as well as emotional distress caused by a physical injury or illness.

If, however, there are no physical injuries, and the suit is solely based on mental or emotional distress, then those damages will likely be taxed by the state and the IRS.

Are class action lawsuit settlements taxable?

Often, the nature of a class-action lawsuit determines whether the settlement can be taxed. The proceeds of a class action lawsuit settlement are taxable in situations where there is no physical harm, discrimination of any kind, loss of income, or devaluation of an investment.

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How Legal Fees are Taxed in Lawsuit Settlements

In most cases, if you are the plaintiff and you hire a contingent fee lawyer, you'll be taxed as receiving 100% of the money recovered by you and your attorney, even if the defendant pays your lawyer directly his contingent fee cut. It shouldn't cause any tax problems if your case is fully nontaxable. However, if you recover taxable damages, be careful.

Imagine you settle an intentional infliction of emotional distress case against your neighbor for $100,000, and your lawyer keeps $20,000. You might believe that would amount to $80,000 in income for you. But, in the eyes of the IRS, the amount you've earned is still $100,000. 

Can your legal fees be deducted? Tax reform passed at the end of 2017 includes a new tax on litigation settlements, which means legal fees are not deductible. This is a particularly bizarre and unpleasant surprise for taxpayers. That's why before a settlement agreement is signed and the case settles, tax advice is vital.

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What is 1099-MISCs for Legal Settlements 

You might receive a Form 1099-MISC if you receive a taxable court settlement.

This form is used to report all types of miscellaneous income, including settlements from legal matters. 

You would report settlement income in box 3, "Other Income."

 Helpful Resource:  What Is IRS Tax Form 1099?: How it Works and Who gets one

When You Would Get a 1099-MISC for a Legal Settlement

As long as the following conditions are met, the IRS requires the payer to send the recipient a 1099-MISC:

• The recipient received more than $600 in a calendar year
• The settlement money is taxable

You won't receive a 1099 for a legal settlement that represents tax-free proceeds, such as for physical injury.

A few exceptions apply for taxed settlements as well. If your settlement included back wages from a W-2 job, you wouldn't get a 1099-MISC for that portion. Rather than a 1099, the funds would instead be included in a W-2.

Other Tax Forms for Legal Settlements

It is possible to receive multiple IRS forms for the same legal settlement.

For example, someone may receive a single settlement containing portions representing emotional distress damages, lost wages, settlement interest, and legal fees. They'd receive a 1099-MISC for the emotional distress damages.

Additionally, they'd receive a W-2 for the lost wages, and a 1099-INT - another type of 1099 for settlement interest.

Due to the fact that their law firm got paid from the settlement proceeds, the firm would also receive a 1099-NEC for their portion of the settlement proceeds.

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How to Avoid Paying Taxes on a Lawsuit Settlement

Most people assume that once they've received the settlement and paid attorney fees, the rest is theirs. Some settlements, however, are subject to taxes. Unfortunately, many people don't realize it until tax time the following year, after much of the money has already been spent.

You can reduce or eliminate the probability that you will have to pay taxes on a lawsuit settlement by following these steps.

Negotiate the amount of 1099 income before you finalize the settlement

Determine whether the defendant will issue a Form 1099 before you sign the settlement agreement. You should negotiate for the 1099 income to be lower than your actual settlement amount if they plan to issue one.

Allocate damages to reduce taxes

In settlement negotiations, you can discuss the allocation of a larger portion of the settlement to nontaxable award categories. For instance, increase the award related to physical injuries and illness, and decrease the award related to emotional distress.

Treat a portion of your settlement as capital gains

In some cases, you might be able to treat part of your settlement as capital gains. For example, it may be possible to classify a settlement for damage to your home or business as capital gain if you sued over damage to the property. Alternatively, your settlement may qualify as a recovery of tax basis, which is not income.

 Helpful Resource: Short-term vs Long term capital gains - What's the difference?

Spread payments over time

Receiving a large, lump-sum taxable settlement can push your income into a higher tax bracket. If you spread your settlement payments over a number of years, you will reduce the amount of income subject to the highest tax rates.

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How to Prepare For Taxes on Lawsuit Settlements

To stay on the right side of the law and navigate the post-settlement process, you might need the help of a tax accountant or tax lawyer. In any case, even if you're not an expert, it's a good idea to set aside a portion of your settlement for the tax bill. Getting a settlement could bump you up to a higher tax bracket and leave you with a much larger April tax bill than usual.

Several factors, including the litigation itself and the state you live in, determine whether or not you have to pay taxes on a settlement amount. To determine the rules that apply to your specific situation, it is highly recommended you speak with an attorney and a tax professional. These professionals can help you avoid paying taxes on a lawsuit settlement and keep more of the money for yourself.