Tax Liability on Legal Settlements

Categories of Settlements & Applicable Taxes

While the rules governing the taxation of legal settlements are fairly intricate, as a general rule, settlements are taxed according to their nature. In other words, if a settlement is awarded as compensation for a physical injury, the tax implications are different than if the settlement covered emotional distress. Below are a few common types of settlements and their corresponding tax implications.
Physical Injury Settlements
If you are awarded a settlement, or even interest on a settlement, for physical injury, pain and suffering as a result of an accident, you are not required to pay taxes on that money.
Emotional Distress Settlements
On the other hand , emotional harm and distress settlements are taxable. However, damages awarded for medical expenses related to the emotional distress of the injury is taxable as well as non-taxable physical injury damages. Other damages for emotional distress related to physical injury are not taxable. In addition, the IRS allows interest derived from an emotional distress "cognitive distortion" to be taxed as ordinary income.
Punitive Damages Settlements
The IRS has deemed punitive damages settlements as income. Therefore, anything you calculate to be a punitive damage settlement would be taxable.

IRS Settlement Taxation Rules

The service of taxability of settlement payments, by the IRS, depends on the nature, and character, of the claim, as well as the settlement agreement itself. Prior to enactment of the Internal Revenue Code (IRC), in 1918, parties to a lawsuit have always been free to settle their disputes. In fact, before the enactment of the IRC, the Supreme Court held in Bank of Metropolis v. New York State, that the principle of law which supports voluntary settlements lies "deep in the roots of our jurisprudence." See Bank of Metropolis v. New York State, 98 U.S. 349, 352 (1878).
Before parties execute their settlement agreement, it is always wise to consult a tax professional to determine the tax effect, in the event of a lawsuit or litigation. A settlement payment is usually either taxable, partially taxable, or non-taxable to the settlement recipient.
To find a right answer on taxability, the IRS considers the underlying origin of the settlement fund, as well as the true purpose of a settlement. In one matter, the IRS held that we may gather the nature and character of a settlement fund to determine whether some, or all, of the fund is excluded from income based on the original intent of the lawsuit. See e.g., May Department Stores Company v. Commissioner, 112 T.C. 151, 156 (1999); Campbell v. Government of the Virgin Islands, 219 F.3d 280, 287 (3rd Cir. 2000).
In Campbell v. Government of the Virgin Islands, the taxpayer sustained personal injuries and brought a wrongful death claim against the municipal government alleging negligence, false arrest, and mental anguish. In 1982, prior to trial, the parties reached a settlement. The I.R.S. sought to tax portions of the settlement payment, which included medical expenses, travel expenses, and several other injury related expenses. In reversing the Tax Court, the appellate court held:
The settlement proceeds were paid to the Victims Compensation Fund by the defendants receiving immunity under the Virgin Islands Tort Claims Act in order to compensate officials who are subject to suit for acts committed while acting in their official capacity. An important component of the Virgin Islands no-fault scheme was to discourage lawsuits and to substitute government compensation.
In Campbell, the appellate court found that the deceased’s damages were not taxable because recovery had the effect of working a "cure," in the sense that the payment from the Virgin Islands Tort Claim’s Fund erased the loss and placed the decedent’s family in the same place they would have been in had the loss not occurred.
The general rule, in tax law, is that courts look to the underlying rights the taxpayer had before litigation, in order to determine whether a settlement is taxable or not. For example, if the lawsuit stemmed from a physical injury, then the settlement payment would not be taxable, as opposed to if the lawsuit was from a violation of some type of an income, property, or profit, which would be taxable. See e.g., Guinan v. United States, 818 F.2d 632, 634 (8th Cir. 1987); McKay v. United States, 957 F. 2d 204, 206 (5th Cir. 1992); See Also Code Section 104(a)(2).

Taxable Vs Non-Taxable Settlements

The first step in determining whether a settlement is taxable or not is to determine the issue for which the settlement was made. Although many state court system dockets contain generic claims such as negligence, breach of contract or other such catch all headings, often times those terms are not sufficient to make a determination as to the proper state and tax category. Often times you can begin with the general issue such as "personal injury" or "implicit in the categories of wrongful termination, or discrimination and emotional distress under the category of employment settlements." "Damages received in law suits for wrongful death payments, personal injury payments and medical payments. Amounts received for physical injuries or physical sickness are not taxable. However, emotional distress punitive damages, interest, libel or slander settlements are all taxable." There are also some factors that cannot exist in order for a suit to be considered solely for physical injury or sickness. These factors are: As can be seen, a case that is primarily for economic loss can also be physical, but if there is no physical injury to the plaintiff, then the entire settlement or award is taxable. The converse is true, if the case is an economic damage case that has physical issues interspersed throughout, then it is possible for it to become a primarily physical case. Determining whether an award is taxable or non-taxable requires some selective parsing of the above rules. If any portion of a case is not taxable, then the entire case is not taxable. Let’s say a plaintiff sues an employer for harassment or discrimination, but the discrimination or harassment causes physical problems to the employee (stress, depression, etc.) and in addition to getting her job back, gets back pay and medical and punitive damages. In that situation, a simple look at the case should tell us that the entire settlement is not taxable. But how about if the medicals were less than the back pay and punitive damages? Can we peg all the back pay and punitive damages to the non-taxable medicals? The answer to that is no. "The tax treatment of a settlement agreement depends on the substance (economic vs. non-economic) of the damages awarded, not on the labels attached in the agreement." In other words, it is the issues of the case that determine the category and therefore the tax status of the settlement.

Declaring Settlement Income

When it comes to settling legal disputes, any settlement income received will be subject to reporting on your tax return. It’s important to be familiar with how to properly mark this down so you don’t accidentally incur any penalties.
In general, individuals are required to report income from settlements as "other income" in the form of a settlement award or an indemnity payment. The general rule is that all gross income received after the transaction is closed must be reported. The money received under an agreement will typically be considered taxable unless you are receiving a refund of prior expenses. These awards are often referred to as "other income" under the Internal Revenue Code (IRC) §61(a). Some examples of income to report are:
To avoid paying taxes on attorney’s fees, parties can ask the attorney to withdraw the full amount of the attorney’s fees from the settlement payment with the plaintiff’s consent. The plaintiff then pays their share directly to the attorney.
Although parties typically report the income on their personal tax returns, there are instances when they may be required to report the income on their business return if they are incorporated. If a corporation receives a settlement or award payment, it is reported on the business tax return because the money becomes "other income" of the business. If the award is for a business asset or damages to goodwill, the amount is subtracted from the basis in the asset as income.
Some payments are not subject to tax. Any payment received as physical injury damages due to a contract violation of an agreement or due to physical injury are excluded from gross income. That said, if the award is for losses of wages, medical expenses or punitive damages, the entire award is subject to taxes.
Even though plaintiffs can receive return of principal funds (involving a return of private capital without gain, which becomes part of a taxpayer’s basis) free of tax, tax-exempt recovery of costs and damages to physical integrity of property still requires the payment of taxes. If the money was taken from your own pocket and given to the defendant, it is tax free. However, any money, costs or expenses not used to offset lost income are taxable — for example, tort awards.

Settlement Related Deductions and Tax Benefits

Settlement proceeds are typically taxed as "ordinary" income and not capital gains, which means the applicable tax rate may be higher than the capital gains rate for individuals making less than $400,000 per year. In general, the lower your tax rate, the higher your after-tax settlement would be. For example, if a settlement was $100,000, your net after tax amount would be $70,000 if the applicable tax rate was 30%.
If a settlement is taxable as ordinary income, one option is to try to negotiate partial relief from IRS Form 1099. For example, if a client pays you $100,000 and you argue that only $50,000 of the settlement is taxable , then the defendant’s lawyer may issue two IRS 1099s (one for $50,000 taxable and one for non-taxable damages of $50,000). You can then pay tax on it accordingly, reducing total tax paid by the plaintiff.
The second option is to force the defendant to issue two payments, the first being taxable and the other being non-taxable (a backdated settlement payment). You can then pay tax on the taxable amount, which may be to your advantage if your taxable income is low in that year.
Where the settlement is entirely tax free, the tax benefit of structuring (deferring) the taxable income may be very beneficial. The later the payment scene, the better for you.

State Taxes on Settlement

Beyond federal tax considerations, state tax laws can also affect whether a settlement is taxable. The differences from state to state can be significant, so it is important in any given case to understand your state’s tax laws, especially considering that states do not always have the same rules as the federal government on taxability of various types of settlements. For example, Illinois law does not require state tax on compensation for a personal physical injury or physical sickness, even if federal taxes are imposed. Likewise, most states exempt from taxation damages received because of physical illness or sickness, such as damages for disfigurement. When a taxpayer resides in more than one state, the laws of offering state and those of residence state must be compared in order to determine where income taxes should be paid.

Get Advice from a Tax Professional

The only logical conclusion to be made from the prior example is for one to consult with a tax professional on how to report legal settlements. It is possible that the tax advisor originally thought that the systemic analysis of the two cases was only applicable to 1099 income, and not applicable to back pay or settlement money for physical injuries. But it is also just as likely that the attorney hired a generalist tax advisor who knows little in the way of following the regulations under section 104.
Either way, an attorney must understand that there are a multitude of income tax rules that interact with each other and the taxpayer is often at the mercy of the advice given by the advisor. Relying on the advice given without conducting a thorough investigation can have grave consequences, and the possibility of liability to the taxpayer . The best way to avoid this liability is to consult with a competent tax advisor to assist you with the reporting and filing of all settlement proceeds.
How does a competent tax advisor find the issue and properly advise? The best place to find a tax advisor is at your local CPA society. The CPA society has a searchable membership directory for CPAs in your area. You are looking for a firm that says they do not pass you off to a junior CPA or clerk. You are looking for a firm that has a tax attorney on retainer. You are looking for a firm that has the manpower on hand to research issues and then report their findings to you quickly. You are looking for a firm that has been in business long enough to have the requisite experience and knowledge. If you do all of the above, then you will have found a someone who can give you the advice you need.