Successful lawsuits can result in settlements of thousands, tens of thousands, or even millions of dollars, which can help pay for some of the losses you have suffered.

However, if you have received or expect to receive a large settlement, it is important to understand the financial impact following the receipt of the settlement funds. You can do this by speaking with your attorney and, if needed,  a qualified accountant. You may need to pay your attorney out of your settlement funds and there may be liens against the settlement. In addition, your settlement may count as income, which can make it subject to income tax. Understanding what you need to pay from your lawsuit ensures you will not run into financial issues and you’ll be able to meet all your obligations.

How Do Lawsuit Settlements Happen?

Lawsuits usually happen as the result of a dispute over an injury or damages. For example, a lawsuit may be filed if an employee feels they have been wrongfully terminated. In business, a dispute can arise if one party feels another party has violated the terms of a contract. Lawsuits also commonly occur after a person or entity’s actions cause injuries to another.

The goal of a lawsuit is to make a plaintiff whole again, by offering them compensation to pay for lost wages, property damages, legal fees, medical expenses, and the other fees an injury or wrongful act may have necessitated. In many cases, plaintiffs need the money from a lawsuit to pay for unexpected costs, to keep their business running, and to address some of the damage they have suffered.

Are Lawsuit Settlements Taxable?

In some cases, lawsuit settlements are taxable. The notable exception is personal injury settlements, such as those that arise out of car accident claims or slip and fall claims. However, each situation is different and since the tax law is complex, it is important for any party in a lawsuit to speak with an attorney and a tax accountant.

What Are the Deciding Factors?

One deciding factor is whether your settlement involves a personal injury in which “observable bodily harm” was present. If your settlement was for a personal injury claim in which your injuries could be visible, your settlement may not be considered income. This would mean it is not taxable and you would not have to list this settlement when filing your income tax forms.

Most settlements are for multiple types of damages, such as lost income, emotional distress, medical expenses, and other costs. These factors can be taxed differently, depending on your circumstances:

  • Medical expenses. Many lawsuit settlements also involve medical expenses and compensation for these visits. The good news is that medical visits for injuries and emotional distress in situations where you did not take an itemized deduction for these costs previously are not taxable. However, if your settlement includes compensation for medical costs and you have taken deductions for those medical expenses in past years, you will be required to pay tax for the year under the “tax benefit rule.”
  • Lost income. Since this compensation is meant to replace income, it’s not surprising that settlement amounts for lost income in employment-related and business-related cases are taxable. They are considered income and you will usually also need to pay social security taxes and Medicare taxes on settlements for lost wages as well.
  • Emotional distress. Most settlements for emotional distress are non-taxable, with a few exceptions. Money used for medical costs related to your distress, including visits to a medical professional, may be taxable. In addition, for your compensation to be non-taxable in this category your distress must stem from the illness or physical injury caused by the incident or accident which formed the basis of your lawsuit.
  • Punitive damages. Punitive damages are awarded in some cases where a defendant’s actions were especially egregious. In many cases, awards for punitive damages and any interest on these damages can be taxable. It can also impact attorney fees and taxation on those fees.

The tax code is complex and is regularly updated. Trying to determine what you owe to state and federal tax agencies after a settlement can vary, depending on your specific circumstances and the facts of your case.

How Does The IRS Come Into Play?

The Internal Revenue Service (IRS) plays an important role in gathering taxes from income and the agency defines gross income very broadly, as “all income from whatever source derived.” However, the IRS creates tax rules which have many exceptions.

If you win money in a lawsuit, the IRS will be interested. The settlement will be taxable in some cases, as will any contingency fees your attorney is owed. However, most personal injury lawsuit settlements and the contingency fees for these cases are not taxable. In the case of claims against a negligent builder for property damage, the settlement may be considered a reduction in the purchase price of the property instead of income, per IRS guidelines. Many settlements arising from business lawsuits are taxable, however.

The IRS has strict rules and significant penalties for failure to pay taxes and for tax evasion. Staying compliant with IRS rules is important to avoid large tax bills and even charges against you later.

How Can Johnson Garcia Help?

Our legal team can review the specifics of your case and can help you determine whether you have a potential claim. Johnson Garcia Law also represents clients in pursuing compensation for medical bills, lost income, and other losses stemming from injuries. Our goal is to secure fair compensation for you so you have the financial resources you need. Since we understand finances are often a concern in difficult situations, we are transparent about our legal fees and can even recommend actions that you might need to take to help you understand any potential tax obligations you may have after your settlement.

Whether you have been injured in a car accident, workplace incident, or in another situation, contact Johnson Garcia Law for a consultation. If you feel you may have a lawsuit, you can also always reach us at (832) 844-6700.