If you’re reading this, chances are you’ve won a lawsuit settlement and are now sitting on a nice, big lump sum of money.
Unfortunately, however, depending on the specificities of the lawsuit and the type of award you receive, you may have to pay taxes to the government on that award.
After all, 97% of civil court cases are settled without trial, so the government wants to get its hands on that money.
The IRS has a large, wordy document on the ins-and-outs of the tax law regarding court settlements. In the eyes of the IRS, certain settlements are taxable, and certain types of settlements aren’t.
Below, I’ll summarize these different kinds of settlements.
Types of Lawsuit Settlements
The IRS divides the types of settlements that can be awarded to a claimant in a lawsuit into two categories.
One category contains claims that are awarded as a result of a physical injury and the other category contains claims that are awarded as a result of non-physical injury.
The IRS defines a physical injury not just as something like a broken bone, but also physical sicknesses like cancer, or the flu.
A non-physical injury would be something that causes an unquantifiable emotional distress like, defamation of character, for example.
There is also one last type of settlement that could be tacked on to either category, but is treated like a separate entity by the IRS.
This would be punitive damages. Punitive damages is money that a judge rules forces defendant to pay that exceeds basic compensation and exists only to punish the defendant.
For example, if you sue someone for lost wages amounting to $1000 and a judge forces the defendant to pay $2000, that extra $1000 is punitive.
Now that we have these definitions, let’s delve into whether or not any of these types of settlements are taxable.
Physical Injury Settlements
Usually, any money that you receive that adds to your gross income has to be reported to the IRS and thusly taxed.
Typically, this would also include settlements from lawsuits.
However, luckily (or unluckily) for you, IRS has certain exemptions when it comes to physical injury settlements.
If you are awarded a settlement in a lawsuit explicitly because you were physically injured, then you do not have to pay taxes on that income.
But this is only true if the settlement is awarded to replace lost wages or to make up for emotional distress as a result of those injuries.
For example, let’s say you were driving your car and another driver t-boned your car, breaking your neck.
Let’s as a result of the broken neck you can no longer work your hypothetical factory job.
As a result of this, you sue the other drive for lost wages, as well as emotional distress.
Then, the judge rules in your favor and you win a $100,000 settlement. Under the law provided by the IRS, all of that income is excludable from the tax because it was awarded as a result of a physical injury.
Make sense? Now, lets take a look at the other side of the coin.
Non-Physical Injury Settlements
Like I previously stated, in the eyes of the IRS, a non-physical injury is an injury in which there was no bodily harm done to the winner of the settlement.
Examples of settlements that would fall under this category are settlements that are awarded as a result of a crimes like libel, defamation, slander, trespassing, property damage, and only emotional distress.
If you have won a settlement as a result of any cases like these, that money has to be reported to and taxed by the IRS.
For example, if your coworkers spreads a false, malicious rumor, about you and that leads to your termination, you can sue for lost wages.
However, you must pay taxes on that money, because you simply incurred no physical harm.
What About Punitive Damages?
Unfortunately, any type of punitive damage, whether it is issued as a result of physical or emotional harm, is not excludable in the eyes of the IRS.
There is one exception, though.
In wrongful death lawsuits, punitive damages may be excluded from your taxable income.
However, this rule exists in a legal grey area, as some states have statutes that exempt wrongful death settlements from being taxed and some state don’t.
In these cases, it is best to consult a lawyer or a CPA to determine if you have to pay taxes on wrongful death settlements.
The Tax Rate on Legal Settlements
We should have a good idea on the general rules for what kind of legal settlements are taxable by now.
With those questions answered, the only one remaining is “If I do have to my taxes, on my settlement, how much should I pay?”
In most cases, you pay the normal federal income tax on your court settlements based on your income bracket.
Unfortunately, if you receive a very large settlement, it may push you into a higher income bracket, forcing you to pay a higher percentage in tax.
For example, if you usually just make $35,000 a year and typically pay a 15% federal income tax, but a court settlement pushes your income to $5,000,000 in that year, you’ll have to pay a higher tax.
In this example you’d get pushed to the highest tax bracket, forcing you to pay 39.6% of your income in tax.
On top of that, you’ll also have to pay your local state and city taxes as well.
But remember, if you’ve won a settlement as a result of physical injury, you only have to pay tax on the punitive portion of that settlement.
So if you get a settlement of $5 million because someone broke your leg, but only $1 million of that is punitive, you only have to pay taxes on that $1 million.
Long Story, Short
At its most basic, the rule for whether or not a court settlement is taxable is that if the settlement is awarded as a result of a physical injury, it can be excluded from taxation.
To be extra safe, though, don’t take my word for it.
Contact a lawyer or a CPA to make sure you’re in the clear.