Check out our Resources section for free tax guides, forms, and more!

855-476-6920 Se habla español

The Tax Implications of Legal Settlements:  Will You Owe The IRS?

Legal settlements can be a welcome relief for those who have experienced personal injury, discrimination, or other legal issues. Unfortunately, many people do not realize that some or all of their settlement money may be subject to taxes. If you’re currently entangled in a legal matter and wondering, “Do I have to pay taxes on my legal settlement?” here’s what you need to know.

Before we can determine if your legal settlement or judgment is taxable, it’s important to understand what a legal settlement entails. A legal settlement is an agreement reached between parties involved in a legal dispute, often outside of a court setting. These settlements can arise from a variety of situations, including personal injury cases, employment disputes, contractual disagreements, and more. Legal settlements typically involve a monetary payment from one party to another, either as compensation for damages or as a resolution to the dispute.

The Taxability of Settlements and Judgments

Now that we have a basic understanding of what legal settlements are, let’s address the burning question on your mind – are legal settlements taxable? The answer is – it depends. While some legal settlements are subject to taxation, others may be exempt, depending on the nature of the settlement. Generally speaking, settlements received for physical injuries or illnesses are tax-free, as they are considered compensation for pain, suffering, and medical expenses. On the other hand, settlements for non-physical injuries, such as emotional distress or defamation, are usually taxable. It’s important to carefully analyze the specific circumstances surrounding your situation to determine your tax liability.

To better understand the tax implications of legal settlements, it’s crucial to examine the various types and how they are treated by the Internal Revenue Service (IRS).

  1. Personal Injury Settlements: As mentioned earlier, settlements received for physical injuries or illnesses are generally considered tax-free. This includes compensation for medical expenses, as well as pain and suffering. Awards for emotional distress directly related to the physical injury or illness are also non-taxable. Punitive damages, however, are always taxable.
  2. Wrongful Death Settlements: Most proceeds awarded in a wrongful death settlement are non-taxable. Certain portions, however, may be taxable. This includes punitive damages, as well as any medical expenses you may have already deducted from your taxes.
  3. Employment Settlements: Settlements arising from employment-related disputes, such as wrongful termination, discrimination, or harassment, are subject to taxation. If you receive compensatory damages for pain and suffering or emotional distress, these are also taxed.
  4. Breach of Contract Settlements: In general, compensation for these types of settlements is taxable.

Per the IRS, there is only one exception where punitive damages could be considered non-taxable. If damages are awarded for wrongful death, where under state law, the state statute provides only for punitive damages, the settlement award would not be included in your gross income.

Unfortunately, due to the Tax Cuts and Jobs Act (TCJA) of 2017, most legal expenses related to personal issues are no longer tax-deductible. This includes attorney fees for personal injury and wrongful death cases. Fees associated with an employment discrimination case, however, are generally tax-deductible.

When it comes to reporting legal settlements on your tax return, it’s crucial to understand the IRS guidelines to ensure compliance. The reporting requirements vary depending on the type of settlement and the amount received. Here are a few key points to consider:

  1. Form 1099-MISC: If you receive a legal settlement of $600 or more and the settlement is subject to taxation, the entity making the payment is required to provide you with a Form 1099-MISC. This form will report the income you received from the settlement, and you must include it on your tax return. If the settlement includes any back wages, these will be reported on a Form W-2.
  2. Form 1040: Depending on the nature of the settlement, you may need to report the income on different sections of your Form 1040. For example, settlements related to personal injuries are reported on Schedule 1. Settlements related to employment disputes, however, are reported on Schedule C or Schedule E.
  3. Consult a Tax Professional: To ensure accurate reporting and compliance with IRS guidelines, it’s highly recommended to seek the assistance of a qualified tax professional. A tax expert can guide you through the reporting process. They can also help you determine the taxability of your settlement (state and federal) and ensure all necessary forms are completed correctly.

Legal settlements can bring both relief and uncertainty. Understanding the tax consequences of a legal settlement is essential to avoid any surprises come tax season. Remember, not all settlements are created equal, and their taxability depends on the specific circumstances surrounding the settlement. Ultimately, seeking professional advice from a qualified tax professional will ensure accurate reporting, compliance, and potential tax savings.