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How Are Lawsuit Settlements Taxed?

How Are Lawsuit Settlements Taxed?
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So you just received a settlement or won a lawsuit? Congratulations! But before you commit all your funds to replacing your damaged car, or even planning a much needed vacation, one question you should ask yourself first is — are lawsuit settlements taxable*? To avoid debt and further stress, you should know exactly how much of the settlement amount could actually be yours before you spend any of it.

The bad news is yes, lawsuit settlements are taxed and yes, the IRS will be ready to take their piece of the pie. Depending on the nuances of the lawsuit and the circumstances involved, the settlement taxes will vary on a case-by-case basis. But the bottom line is usually this: After you collect a settlement, the IRS typically regards at least some of that money as income, and taxes it accordingly.

Here is more information on some of the ways lawsuit settlements are taxed and other issues that can affect how much of the settlement money will actually be yours to keep.

Taxes on personal injury settlements

The IRS usually does not consider the some types of the money received through personal injury settlements as wage or salary and hence, there are no taxes. For example, if a plaintiff in a suit suffers physical injuries or sickness as a result of the defendant’s actions, the compensatory damages addressing those injuries should be tax free.

However, that isn’t always the full story. In some cases there is money awarded called “punitive damages” or “exemplary damages.” This is not money awarded to compensate, but awarded (usually in a trial) in order to “punish” the defendant who caused harm and to deter the defendant and others from engaging in the conduct that lead to the suit. The IRS considers this type of damages taxable.

Damages for emotional distress

Emotional distress is a type of mental suffering or anguish induced by an incident of either negligence or through intent. The courts recognize emotional distress as a type of damage that can be compensated through a civil lawsuit. If you win your case or receive money through a settlement, the tax treatment would depend on the case and the facts involved. There are two types of emotional distress claims:

  • Negligent infliction of emotional distress: This is when someone commits an unintentional act that causes emotional harm, such as a drunk driving accident that causes injury. For example, a woman who has witnessed her spouse dying as a result of a DUI accident can sue the driver for this type of emotional distress.
  • Intentional infliction of emotional distress: This type of claim occurs when the defendant intentionally inflicts emotional trauma upon another individual. An example of intentional infliction of emotional distress is constant tormenting or verbal attacks which result in distress so significant, it causes physical and mental symptoms.

It is important to know that the amount awarded in the settlement that covers the medical effects of distress resulting in bodily symptoms such as insomnia, headaches, stomach disorders are usually not taxed.

If you sue someone for reasons other than personal injury, such as employment discrimination or copyright infringement, the award you may receive is taxable as part of your income.

How lawsuit settlements are paid

Lawsuit settlements can take a long time to wrap up. If you factor in investigation processes, negotiations, claims and evaluations, it may take six months to a year, even without a trial. Some of the steps that are usually part of the process are:

  1. Signing documents and release forms
  2. Release of the check by the insurance company
  3. Payment of any liens
  4. Payment of any legal fees and court costs
  5. Receiving your settlement money

Let us take a closer look at some of these steps to help you understand where your money might go.

How is the settlement paid?

Since there are multiple stakeholders involved in the lawsuit settlement process, the insurance company will work to ensure everything is finalized before payment so it can avoid re-opening the case due to additional claims or undiscovered issues post-settlement. Payments must be made to each person or entity that has a stake in the settlement amount, which could include:

  1. Medical liens: A lien is something that ensures a person, group, or business is compensated for services or goods provided to someone else. A medical lien is a guarantee to a lienholder to recover medical costs associated with a personal injury, such as an automobile accident.
  2. Legal fees: In addition to taxes, part of your settlement may go to attorney’s fees. If the attorney who represents your case does so based on a contingency fee, this fee will be deducted from the award. The contingency fee is usually not a fixed amount, but generally a percentage. Most personal injury lawyers charge 33.33% if the case settles without filing a lawsuit and up to 40% if a lawsuit is filed. These fees are in addition to any court costs.
  3. Your share: Once each party involved in the claim proceeds process receives their share, the remainder of the income goes to you.

Once you receive a settlement, what next?

There are different ways to collect a lawsuit settlement. You could opt for a one-time lump sum amount, or receive structured settlement. The way you receive your settlement could have tax implications, so a few of the key advantages and disadvantages of a structured settlement are listed below.

Structured Settlement Pros Structured Settlement Cons
· Structured settlements may offer plaintiffs the certainty of payments over a fixed period, may have less tax consequences than lump sum payments.

· Parties can dedicate funds from a structured settlement to cover advances in medicine so that if medical science develops a new cure, the plaintiff can access the treatment.

· A structured settlement may help parties who further apart in their settlement negotiations to reach an agreement acceptable to both parties.

· While structured payments might account for inflation, unexpected changes in the economy could make the payments too small.

· Although a rare occurrence, the future solvency of the paying party should be taken into consideration. If the paying company goes bankrupt, the plaintiff could be out of luck.

Lump Sum Settlement Pros Lump Sum Settlement Cons
· You may receive a larger amount than with a lump sum payment, which you can invest or use to pay off large debts, providing you with flexibility.

· Lump sum payments may be good for small settlement amounts, or situations where long-term medical expenses are not expected.

· If you invest your lump sum unsuccessfully, you could lose much or all of your settlement.

· If you don’t have experience handling large amounts of money, a lump sum can be overwhelming.

You can consult your attorney to help you decide what would be the best option in your case.

Bringing it all together

No matter what kind of settlement you receive or how it is taxed, it is important to be clear about how much money you will ultimately receive, and prioritize how to spend or save that money. The idea behind the payment of a lawsuit settlement is to make the injured person whole, but thanks to fees, bills and taxes, that may not happen, so you should exercise care in how you spend the money and do your best to avoid debt.

How to deal with debt after a settlement

Compensation received through lawsuit settlements could also help you cover your outstanding medical or credit card debts. However, if you are still grappling with your debt despite a settlement, you may want to learn more about managing your finances. Our free How to Manage Debt guide can help put you on a better financial path.

*Freedom Debt Relief does not provide legal or tax advice and the above should not be construed as such.

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Hirak Bhayani is a former private banker with India's largest bank where she managed the wealth portfolios of ultra HNIs. She recently completed her Masters in Analytics from Duke's Fuqua School of Business and when not building predictive models, writing on banking and finance, or daydreaming, she loves reading and sampling the many varieties of Chicago deep-dish pizza.