Are you receiving a settlement and wondering if you’ll have to pay taxes on it?
Have you wondered: “Are settlements taxable?”
Ready to receive a settlement but worried about the tax hit?
You’re in the right place!
This article will review common questions plaintiffs have when navigating the settlement process. The truth is that settlement taxation is complex. Some types of settlements are completely tax-free, while others get hit hard with taxes. And there are some significant pitfalls to watch out for.
In this comprehensive overview, we’ll share seven tips and pointers for determining if your settlement is taxable. And if your settlement IS taxable, we’ll outline some of our best tax-saving strategies.
Before we dive in, please note: the information contained in this article is intended for general informational purposes only and is not intended to be tax advice.
Alright, let’s jump right into our seven tips and pointers for figuring out if your settlement is taxable:
#1 – The Default Rule is Settlements Are Taxable
We’ll share the bad news first: The default rule is that legal settlements are taxable income.
The IRS says, “All income is taxable from whatever source derived,” including from legal settlements unless an exception to taxation applies. In other words, unless your settlement falls into an exception that avoids taxation — your settlement will be taxed.
And more bad news: In 2005, the United States Supreme Court ruled that the amount you, the plaintiff, must pay taxes on is the TOTAL gross settlement. This includes the amount you pay to your attorneys for their legal fees.
For example, if you get a $1,000,000 settlement, and you pay $400,000 in attorney fees, you’ll only actually receive $600,000. But, unless an exception applies, the IRS will require you to pay taxes on the entire $1,000,000!
This is true even if the defendant paid your attorney directly for their fee and even if the money owed to your attorney never passes through your hands. We’ll come back to this tax challenge in Tip #6 (paying taxes on the entire settlement) — but this can be an absolute gut punch for plaintiffs.
The starting point should always be to assume your settlement IS taxable. Then, look for exceptions and explore tax planning strategies.
#2 – The “Origin of Claim” Rule Determines Taxation
The “origin of the claim” rule is used to determine how lawsuit settlements and judgments are taxed.
The tax treatment of the settlement depends on what the plaintiff is seeking to recover through their legal claim.
Here are some examples:
- If someone sues for lost business profits, the settlement will be taxed as lost profits (ordinary income).
- If someone sues for lost or unpaid wages, then the settlement will be taxed as wages.
- If someone sues their employer for discrimination, the settlement will be taxed as ordinary income.
- In a defamation lawsuit, the settlement will be taxed as ordinary income because the origin of the claim was for damage to reputation.
So, the nature of the original claims made in the case largely determines how the ultimate recovery is taxed, regardless of how the case ends up being resolved.
This “origin of the claim” rule means plaintiffs and their lawyers need to carefully consider the tax implications when first asserting their claims and throughout the litigation process.
In short, your settlement compensates you for whatever type of damages you originally claimed — and the settlement gets taxed accordingly.
#3 – Settlements for Personal Physical Injuries Are Tax-Free
Now for some good news: If your settlement is for a personal physical injury or physical sickness, the settlement is 100% tax-free!
Here are some examples of tax-free injury settlement cases:
- Car crash cases (if you suffered injuries like whiplash, had medical bills, etc.)
- Slip and fall cases
- Workplace injury cases if you suffered physical harm
- Dog bite cases
- Medical malpractice cases
It’s important to note that this exception only applies to physical injuries — injuries to the body.
And this exception is actually more limited than you might think.
Since 1996, the IRS has ruled that your injury or sickness has to be clearly physical in nature to qualify for tax-free treatment. Things like depression, insomnia, headaches, stomach issues from stress, and emotional distress are often NOT considered physical by the IRS.
However, a physical injury that causes emotional distress IS considered physical and can still qualify for tax exclusion. See the difference? It’s about the sequence of events. The origin of the claim must be a personal physical injury in order for subsequent damages to be tax-free.
For example, if you undergo a botched surgery and sue for medical malpractice, develop PTSD, and then suffer emotional distress from the PTSD — that whole chain of events is likely excluded and would be tax-free.
But if you’re just stressed out from work, develop headaches, and claim emotional distress from the headaches, that’s considered a symptom of mental distress, so it would be taxable.
The key is your lawsuit must claim damages specifically for physical harm, and you need evidence (like medical bills and treatment) to prove it.
The personal injury exception to taxation is one of the most common and helpful ways to avoid being taxed on a settlement.
#4 – Medical Expenses Are Tax-Free
The IRS considers reimbursements for medical costs to be tax-exempt payments, even if the rest of the settlement is taxable income.
This is a great opportunity to work with your attorney to make sure your settlement agreement with the defendant specifically allocates a reasonable portion of the settlement to both past and future medical expenses.
Spelling out this allocation in the settlement agreement provides you with valuable proof if the IRS ever asks why you didn’t pay taxes on that portion of the settlement.
Any amount of a settlement that is specifically allocated to past and future medical expenses will avoid taxation — which puts more money in your pocket.
#5 – Allocating Damages Can Save Taxes
In many cases, lawsuits involve multiple types of damages: lost income, medical costs, emotional distress, pain and suffering, and so on.
Allocating specific settlement amounts to each type of damage can minimize your tax bill.
As we discussed in #2, how a settlement is taxed depends on the origin of the claim and the nature of the settlement.
However, often, several types of claims are involved in a single lawsuit. For example, if you are involved in an employment lawsuit, your settlement could be made up of several different damage types:
- A portion of the settlement might be for lost wages (which requires withholding of taxes and is reported on a Form W-2);
- A portion may be for non-wage emotional distress damages (which is taxable, but not as wages, so it would be reported to you on a Form 1099);
- A portion could be for some reimbursed business expenses (usually nontaxable unless you had already deducted them);
- And, as we talked about in Tip 4, a portion of the settlement could be allocated to past and future medical expenses (which is tax-free)
So, when feasible based on your claims and facts, work with your attorney to allocate more of the settlement to tax-free or non-wage damages in your settlement agreement.
This is perfectly legal and could save you a significant amount of money.
#6 – Many Plaintiffs Cannot Deduct Their Attorney’s Fees
Here is where things get tricky. The Supreme Court rulings we mentioned in Tip #1 stated that plaintiffs must pay tax on their full GROSS settlement.
For many years, this didn’t harm plaintiffs because they could just deduct the attorney fee portion of the case on their tax return — meaning they wouldn’t have to pay any tax on the amount paid to the attorney.
However, since the passage of the Tax Cuts and Jobs Act in 2017, many plaintiffs can no longer deduct their attorney fees. Why? Because the Tax Cuts and Jobs Act removed miscellaneous itemized deductions from tax returns, which was the main way many plaintiffs had previously deducted attorney fees.
Let’s look at our previous example again: Assume you get a $1,000,000 gross settlement and pay $400,000 to your attorney in legal fees. You’re left with $600,000.
But, in most cases, you’ll have to pay taxes on the full $1,000,000. Why? Because you can no longer deduct the legal fees as a miscellaneous itemized deduction since that deduction was removed by the Tax Cuts and Jobs Act.
This change in the tax law means, in most cases, you have to pay tax on your TOTAL recovery even though up to 40% went straight to your lawyer.
There are a handful of case types that were not impacted by the Tax Cuts and Jobs Act and allow plaintiffs to deduct their legal fees on their tax returns.
The main types of cases where plaintiffs still CAN deduct attorney fees are employment discrimination or retaliation lawsuits and whistleblower claims. In personal injury cases, a deduction isn’t needed because the settlement is tax-free.
In nearly every other case type, plaintiffs cannot deduct their attorney fees, so plaintiffs are paying taxes on money paid to the attorney — money they never receive. This is a wildly unfair outcome and likely an unintended consequence of the Tax Cuts and Jobs Act.
This unfair outcome begs the question: What can be done to avoid this huge tax hit? Tip #7 shares two powerful planning strategies that can help you not lose a large chunk of your settlement to taxes.
#7 – Using the Plaintiff Recovery Trust and Structured Settlement Annuities Can Dramatically Reduce Taxes
Here’s some good news: There are two specialized tax planning tools that can minimize your tax bill.
The first tool that we use with clients nationwide is the Plaintiff Recovery Trust. This specialized trust allows you to avoid being taxed on legal fees in cases where you cannot deduct legal fees.
In Tip 6, we talked about how many plaintiffs cannot deduct their attorney fees. The Plaintiff Recovery Trust is the solution to that problem.
The Plaintiff Recovery Trust allows plaintiffs to only pay taxes on the settlement money they receive after their attorneys get paid their legal fees. Depending on which state you’re in, using this tool alone can often double what you get to keep after taxes.
The second tool we use with clients nationwide is called a structured settlement annuity. A structured settlement annuity allows you to receive your settlement payments over two or more years rather than in a lump sum in the year the case settles.
When you use an annuity, you only pay taxes when you receive payments from the annuity. This “spreading out” of the settlement often lowers your tax rate, which then reduces the total taxes you pay on the settlement.
Using either one of these tools can greatly increase your after-tax net recovery.
And by combining these tools, we can often double or triple what you get to keep after taxes.
How would you like to double or triple your net settlement?
IMPORTANT NOTE: Both of these tools must be set up before you settle your case. Once the case has settled, it’s too late to use either strategy, and you’ll end up losing a large portion of your settlement to taxes.
So, if you are in the middle of a lawsuit and you’re worried about taxes, please reach out now so we can do some proactive planning. Once your case settles, there’s nothing we can do to help you — so don’t wait!
Understanding Settlement Taxes: Your Key Takeaways
Let’s recap what we covered in this article:
- #1 – The Default Rule is Settlements Are Taxable
- #2 – The “Origin of Claim” Rule Determines Taxation
- #3 – Settlements for Personal Physical Injuries Are Tax-Free
- #4 – Medical Expenses Are Tax-Free
- #5 – Allocating Damages Can Save Taxes
- #6 – Many Plaintiffs Cannot Deduct Their Attorney’s Fees
- #7 – Using the Plaintiff Recovery Trust and Structured Settlement Annuities Can Dramatically Reduce Taxes
Taxation of settlements is complex. But you CAN avoid paying taxes on some or all of your settlement money with some strategic planning.
If you are getting a legal settlement and are worried about taxes, we are here to help you.
We offer a free, no-hassle 15-minute phone call for plaintiffs nationwide. Book your call right now by clicking on the link.
If we determine on the call that you will have to pay taxes on your settlement, our firm will prepare a customized, no-cost tax savings analysis for you showing how much money you can save with the tax strategies shared today.
If you want a sneak peek at how much these tax planning strategies can save you, check out our free Settlement Tax Calculator that will estimate how much you’ll have to pay in taxes — AND it shows you how much more money you can keep by using one or both of the strategies we shared in this article.
But please don’t wait to reach out since ALL of the tax planning strategies discussed in this article have to be set up before settlement. It’s painful when someone pays way too much in taxes because they didn’t do planning before settlement.