The answer to the common question, “Do you have to pay taxes on a settlement?” depends on the type of compensation included in your settlement. In many cases, payments for physical injuries or illnesses are not taxable, but other components like lost wages, punitive damages, or interest may be subject to taxation. Understanding the tax implications of your settlement can help you plan accordingly and avoid surprises when filing your taxes. Working closely with our trusted personal injury lawyers can help you understand your settlement from the beginning. Explore this article for more information on what is and isn’t taxable in a personal injury settlement.
What Does the IRS Say About Personal Injury Settlements?
IRC Section 104 provides clear guidelines about the taxability of personal injury settlements, but the specifics depend on the type of compensation you receive. According to this tax code, compensation for physical injuries or illnesses is generally not considered taxable income, provided the settlement is directly tied to such damages. This includes payments for medical bills, pain and suffering related to physical injuries, and emotional distress caused by a physical injury. However, not all settlement components are tax-exempt.
It’s important to note that even if a settlement is generally tax-free, the IRS requires you to report the total settlement amount on your tax return if you receive a Form 1099-MISC. Working with a qualified attorney and consulting a licensed tax professional can help you understand how these rules apply to your specific case and ensure you comply with federal tax laws. Let’s break down the specifics to help you understand what is and isn’t subject to taxes.
Are Damages for Medical Bills Taxed?
No, damages for medical bills are generally not taxed. If the compensation is specifically for medical expenses related to physical injuries or illnesses, it is excluded from taxable income. If you claimed a tax deduction for those medical expenses in a prior year, the reimbursed amount might become taxable under the IRS’s “double-dipping” rules.
Are Damages for Lost Income Taxed?
Yes, damages for lost income are taxable. Since this portion of your settlement replaces wages that would have been taxed if earned, the IRS requires you to include these amounts as taxable income. Both federal and state income taxes may apply.
Are Payments for Pain and Suffering Taxed?
Payments for pain and suffering may or may not be taxable, depending on the circumstances surrounding your case.
When Taxes Would NOT Apply for Pain and Suffering:
If the pain and suffering stem directly from a physical injury or illness, the payments are generally not taxable. For example, if you were injured in a car accident, suffered permanent disfiguration, and received compensation for emotional distress associated with the injury, the payment is not taxable because it is related to a physical injury.
When Taxes WOULD Apply for Pain and Suffering:
If the pain and suffering is unrelated to a physical injury, the payment may be taxable. For example, say you experienced severe emotional distress due to a wrongful termination lawsuit, but there was no associated physical injury. The settlement you receive for emotional distress would likely be considered taxable income by the IRS.
Always consult a tax professional to clarify your specific situation.
Are Punitive Damages Taxed?
Yes, punitive damages are generally taxable. These damages are awarded to punish the at-fault party and are considered income by the IRS, regardless of the type of case or injuries involved.
Are Property Damages Taxed?
No, compensation for property damage is typically not taxable. The IRS treats these payments as reimbursements to restore or replace the damaged property. If the compensation exceeds the property’s original value, the excess amount may be taxable.
Are Attorney Fees Taxed?
Attorney fees can be a complicated area. If the entire settlement amount is taxable, attorney fees are also taxable, even if the lawyer receives the payment directly.
Are Interest Payments on Settlements Taxed?
Yes, interest payments on settlements are taxable. If your settlement accrues interest while waiting for disbursement, the IRS considers that interest taxable income. Be prepared to report it on your tax return.
For non-taxable portions of the settlement, the fees tied to those damages are not taxable. Our office highly recommends consulting a tax professional to ensure proper handling of attorney fees.
Do You Pay Taxes on Workers’ Comp?
Workers’ comp isn’t taxed. This includes payments for medical treatment, lost wages, and other workers’ comp benefits. However, suppose you file a third-party lawsuit for a work injury in addition to a workers’ comp claim. In that case, the taxable status of that settlement will depend on the type of damages awarded, following the rules outlined above.
Do I Have To Report Settlement Money to the IRS?
Yes, in most cases, you are required to report settlement money to the IRS, even if portions of it are not taxable. The IRS requires transparency about all forms of income or compensation, and settlements are no exception. If your settlement includes taxable components—such as lost wages, punitive damages, or interest—you must report these amounts as income on your tax return. Even for non-taxable portions, you may still receive a Form 1099-MISC from the payer, which necessitates reporting the total amount to the IRS.
How Do I Avoid Taxes on My Settlement Money?
While you cannot avoid paying taxes on portions of your settlement deemed taxable by the IRS, there are legal ways to minimize your tax liability:
- Structured Settlement Annuities (SSAs): Opting for a structured settlement can spread payments over time, potentially reducing your taxable income in a single year. This can help lower your tax bracket and overall liability.
- Work With a Qualified Attorney: Attorneys familiar with settlements can help you negotiate agreements that categorize as much compensation as possible into non-taxable areas, such as physical injury compensation or property damages.
- Consult a Tax Professional or CPA: A licensed tax professional can help you navigate complex tax laws and ensure your settlement is reported correctly. They can also identify potential deductions or strategies to reduce your tax burden.
Residents of Winston-Salem, Greensboro, Lexington, Salisbury or elsewhere in North Carolina can benefit from working with local legal professionals like Lewis & Keller as well as tax experts who understand both federal and state regulations. Taking proactive steps can save you from unnecessary tax complications and help you understand if you have to pay taxes on a settlement.
