If you win a lawsuit, do you have to pay taxes? It’s one of the most common questions we hear at Fields Injury Law.
When you’ve suffered a serious injury, you’re already dealing with recovery, insurance, and missed time at work. Worrying about the taxes you may owe on a settlement you may receive only adds an extra layer of stress to your situation.
While each individual case is unique, the good news is that most personal injury settlements in Minnetonka are not taxable. However, there are some situations where taxes on settlements may apply.
Do You Pay Taxes on a Lawsuit Settlement in Minnetonka?
The IRS considers income from any source to be taxable, but there are a few exceptions. One of them is for damages awarded in a lawsuit based on a personal injury or physical sickness. This is laid out in IRS Internal Revenue Code (IRC) Section 104.
That's good news for most winners of a personal injury claim. However there is some nuance here. The same section 104 of the IRC also makes it clear that damages can be taxable in some situations.
Why are some settlement payments taxable, while others are not?
It essentially boils down to what the settlement is intended for, often referred to as the “origin of the claim”.
When Is a Minnetonka Lawsuit Settlement Not Taxable?
When it comes to understanding the origin of the claim, there are four situations when a legal settlement is not taxable: personal injury, medical expenses, pain and suffering, and wrongful death.
Physical Injury Settlements
Settlements awarded in cases involving physical injuries are typically exempt from taxation. Some examples include car or motorcycle accidents, slip-and-fall accidents, dog bites, and other physical injuries.
Those funds awarded are intended to compensate the victim for the injury itself. Because the settlement is not a replacement for lost income, it is generally not considered taxable by the IRS.
Medical Expenses
Settlements that include money intended to recover medical expenses are also exempted from taxation. This can include emergency room bills, the cost of surgeries, rehabilitation, and physical therapy. If it's related to medical care and recovery from the injury, the settlement is generally not considered taxable.
However, there is some nuance. If the plaintiff has previously deducted those medical expenses from a tax return, there is a possibility that a settlement for medical expenses may be subject to taxation.
Consulting an accountant or tax professional is the best way to understand if the settlement is taxable.
Pain and Suffering Tied to Physical Injuries
The IRS also typically refrains from placing taxes on settlements related to pain and suffering, if it is related to a physical injury.
For example, if a person slips and falls at a Minnetonka coffee shop, the emotional distress linked to the injury and their recovery may result in an additional settlement amount.
Wrongful Death Claims
When a person is killed as the result of someone’s actions or negligence, their family may receive a wrongful death settlement. This type of settlement is generally not taxable, because it is compensation for a physical injury that resulted in death.
When Are Settlement Payments Taxable in Minnetonka?
Many settlements include payouts in categories beyond personal injury or medical bills. Plaintiffs are often surprised to learn that taxes do apply to some settlement types.
Lost Wages
Settlement funds intended to replace lost wages may be subject to taxation. From the IRS’s point of view, it's money you would have paid taxes on anyway, so they are going to take their cut.
However, there are some cases where the IRS has treated lost wages as part of physical injury recovery, and considered them not taxable.
Every case is unique, and these distinctions can get complicated quickly. It's best to discuss taxes on settlements with your attorney and a tax professional for specific advice.
Punitive Damages
Punitive damages are a financial punishment that may be awarded to victims in cases involving reckless or intentional misconduct.
For example, drunk drivers are often hit with punitive damages because their actions intentionally endangered people.
Because these damages are intended to punish the defendant, and not to help the victim with recovery from an injury, the IRS considers them a type of settlement payment that is taxable.
Emotional Distress Without Physical Injury
When a settlement related to emotional distress is not connected to a physical injury, then that settlement is generally considered taxable. Common examples are harassment suits or discrimination claims, whose settlements are subject to taxation.
Interest on the Settlement
One aspect that often surprises clients is taxation on a settlement’s interest. If the defendant appeals the verdict, they won’t pay the settlement while the appeal is ongoing. If they lose the appeal, they would owe the initial settlement plus interest accrued while the payment is delayed. That interest is likely to be subject to taxation, even if the rest of the settlement is not.
Attorney Fee Issues
One point to consider around how lawsuit settlements are taxed is that attorney fees themselves can sometimes create tax complications.
When a settlement is paid out, the payment is often sent directly to the attorney, who then subtracts their fees, and hands the rest to their client.
The possible issue here is that in a non-injury related settlement, the IRS may tax the victim based on the full amount awarded, before attorney’s fees are taken.
For example, a plaintiff wins a workplace discrimination suit and is awarded settlement. Their attorney charges a 25% fee. However, the IRS will likely tax them on the entire settlement amount, before they paid the attorney’s fee.
That can create an unexpected tax burden for the plaintiff.
IRS Forms & Reporting
Plaintiffs that receive a settlement may also be surprised to receive Form 1099 from the IRS. Your gut reaction may be to believe that this is essentially a tax bill, but that isn’t always the case.
Form 1099 is a reporting document that the defendant uses to declare to the IRS that a payment was made to the plaintiff.
If that settlement was compensation for physical injuries and medical expenses or related pain and suffering, the settlement is still generally considered tax exempt. However, additional settlements for lost wages or punitive damages may still require taxation.
The Importance of Settlement Language
Whether you will owe taxes on a settlement comes down to how the settlement is classified.
However, an attorney cannot simply label damages any way they want to avoid taxes for the plaintiff. The courts and the IRS will look at the facts behind the claim, not just the words used in the settlement.
If a Minnetonka plaintiff has lost a year of work and income because of an injury, the parties can’t simply say that all recovery is for pain and suffering. Clearly part of the settlement would be related to lost wages.
A vague settlement agreement that doesn’t have a breakdown of how the total was reached may attract more attention from the IRS than one that has a complete breakdown of how the damages are categorized.\
An experienced attorney can help ensure that settlement language accurately breaks down the nature of damages.
Common Examples of How Lawsuit Settlements Are Taxed
To illustrate how lawsuit settlements can potentially be taxed, we’ve prepared several examples. These examples are solely intended to illustrate how a potential settlement can be taxed, and do not represent the value of your own possible settlement.
Because every case is different, you should consult a knowledgeable personal injury attorney for advice specific to your own case.
Minnetonka Car Accident Settlement
A plaintiff is the victim of a car accident and is awarded a six-figure settlement to cover medical bills and pain and suffering. Because the settlement amount is intended to pay for medical costs as well as pain and suffering, the total would generally not be considered taxable.
Employment Discrimination Settlement
A plaintiff wins a workplace discrimination suit and is awarded a settlement amount including back pay, and emotional distress. Because the settlement is not related to injury or medical bills, some or even all of the payment would be taxable.
Punitive Damages
A pedestrian in Minnetonka is hit and seriously injured by a drunk driver. The court awards a settlement to the victim to cover their physical injury and medical costs. The judge adds an additional five-figure sum in punitive damages. The physical and medical damages are generally not taxable, however the punitive damages are taxable.
Fields Injury Law: Minnetonka Personal Injury Law Firm
If you’re wondering “do I have to pay taxes on a lawsuit settlement?”, the answer depends entirely on the way the settlement is categorized. When a settlement is based around physical injury, medical bills, and pain and suffering related to that injury, it's generally not taxed.
When a settlement involves lost wages or emotional distress that is not related to an injury, some or all of the settlement may be taxable.
The most important takeaway is that each and every case is unique. Some settlements may be a majority tax-free, while other settlements may have portions that are taxable.
The best way to understand your potential tax obligations is to consult with your attorney and a tax professional before accepting a settlement.
If you’ve been injured, contact Fields Injury Law for help with your Minnetonka claim. We offer a free initial consultation to discuss your options. Contact us today, and get professional help with your injury claim.
Fields Injury Law — Attorney responsible: Steve Fields
DISCLAIMER:This blog post provides general information regarding taxes and lawsuit settlements. Individual cases will vary significantly. For personalized guidance on your specific situation, it is essential to consult with a legal expert.
