Finally receiving a settlement check after a long legal battle feels like a massive relief, and you received the compensation you deserved. Below we provide some guidance on how your settlement check is likely to be treated by the IRS. This is not tax advice. Every individual is unique, so it’s important to get clarity with an accountant or tax attorney so you don’t have a large tax bill or penalties down the road.
What is the Origin-of-the-Claim Doctrine?
The IRS determines how settlement money is taxed by looking at what the payment is intended to replace, which is known as the origin-of-the-claim doctrine. If the settlement check replaces money that would have been tax-free like reimbursement for a hospital bill, the settlement is usually tax-free. If it replaces money that would have been taxable like your salary, the settlement is usually taxable. The specific wording and allocation of damages in a settlement agreement are very important because they determine how the IRS will tax the amount you received.
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When Do You Get Taxed on Settlement Money?
The IRS usually treats lost wages, profits, punitive damages, and interest as taxable income. Here’s why:
Lost Wages & Profits
If you sued a former employer for wrongful termination or a business partner for breach of contract, a significant portion of your settlement might be for lost wages or lost profits. Because the settlement amount would have been taxable income had you received it through your regular paycheck, any settlement replacing that income is also taxable.
Punitive Damages
Unlike compensatory damages which are to reimburse a victim for medical bills, lost wages, property damage, or pain and suffering, punitive damages are to punish the defendant for their negligent behavior. Examples of these types of cases include fraud, unsafe working conditions, malpractice, defective products, driving drunk, wrongful death, medical negligence during childbirth, or an injury due to a pressure cooker accident.
When Are You Not Taxed on Settlement Money?
Usually settlements awarded for a physical injury or sickness are not taxable because the government considers this money as reimbursement for your loss, not as new income. Examples of tax-free settlements usually include:
Physical Injury
If you were in a car accident and received a settlement due to physical injury you sustained, the portion of the money allocated for that injury is typically tax-free. This exemption applies whether you receive the money in a lump sum or periodic payments.
Medical Expenses
Damages compensating you for medical expenses you paid to treat a physical injury are also usually tax-free. The thing to be aware of is if you previously deducted those medical expenses on your tax return and received a tax benefit, you must include that portion of the settlement as taxable income. This is to prevent double-dipping, claiming a deduction one year and then receiving the same amount tax-free through a settlement.
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Are Emotional Distress Settlements Taxable?
Emotional distress settlements may be taxable depending on the type of claim and how the settlement is structured. Here are examples of when settlements may be tax exempt:
Slip & Fall Accident
If a slip and fall accident settlement compensates you for medical expenses, pain and suffering, or physical injuries sustained in the fall, it is usually not taxable.
Wrongful Termination Claim
If your wrongful termination caused a physical injury or illness that led to severe stress or another diagnosed medical condition, the portion of the settlement specifically compensating for that physical harm could be tax-free. There usually needs to be a clear link between being wrongfully terminated and how it caused physical injury or illness to be seen as non-taxable income.
Defective Product Claim
If a defective product causes a physical injury, (e.g., burns, broken bones, poisoning, faulty airbags that didn’t deploy in a crash) or a medical condition, the portion of the settlement covering medical expenses, pain and suffering, or permanent disability is usually tax-free.
Contact Postman Law for a Free Personal Injury Claim Consultation
Time is critical in personal injury cases because of the statute of limitations in your state and the type of claim. From the date of the accident, you usually have 1-3 years to file a claim, but it’s important not to wait so that you meet all deadlines and don’t risk losing your right to compensation. Postman Law’s personal injury attorneys have offices in Chicago, Cincinnati, Denver, and Minneapolis, but also help clients nationwide. Schedule a free case evaluation today by filling out our online form or calling us at 844-POSTMAN, so we can discuss your options and ensure your rights are protected right away.
Disclaimer: This blog post is for informational purposes only and does not constitute legal advice. For specific guidance regarding your situation, consult a licensed attorney.