Do You Have to Pay Taxes on a Settlement?
If you resolve your personal injury claim with a settlement between yourself and the other party, first, enjoy your victory. Then, think about the large sum of money you are about to receive. You will have to pay your attorney’s fees and any court costs in most cases, on top of using the settlement to pay for your medical bills, lost wages, and other damages. Finding out you also have to pay taxes on your settlement could really make the glow of victory dim. Luckily, personal injury settlements are largely tax-free.
Federal and State Settlement Taxation
As a general rule, neither the federal nor the state government can impose taxes on the proceeds you receive from a personal injury claim. Claim proceeds are more or less tax-free, whether you settled your claim or went to trial to get a jury verdict. The federal Internal Revenue Service (IRS) and the California state government cannot tax settlements in most cases. There are, however, exceptions to this rule. You may face taxation on the following:
- Breach of contract settlements or awards. If a breach of contract caused your injuries or physical illness, and the breach is the basis of your lawsuit, the government has the right to tax any damages you receive.
- Punitive damages. Punitive damages, or those awarded for the sole purpose of punishing the defendant, are taxable in California. Your Bakersfield injury attorney will ask the judge or jury to separate the verdict or settlement into punitive and compensatory damages. That way, the IRS will only tax you for the punitive damages.
- Lost wages. This economic damage award is typically taxable since the government sees it as money you would have had to pay taxes on were it not for the injury. Since your normal wages would have been taxes, your lost wage award will be as well. The IRS has the right to impose the taxation of your award as it sees fit.
- Interest on judgment. If the court adds interest to the verdict for the amount of time the claim has been pending, the government may tax this portion of your award or settlement. For example, you may have to pay taxes on interest you receive for a claim you brought in 2014 that did not resolve until 2017.
Keep in mind that the only non-taxable claim settlements are those that arise from physical injury or illness claims. If your lawsuit deals with emotional distress or employment discrimination, the government will tax your settlement. You may be able to elude taxation if you can prove even the smallest amount of physical injury. A lawyer may be able to help you with this burden of proof and ensure you receive a non-taxable settlement as much as possible.
How to Pay Settlement Taxes
If part or all of your settlement is taxable, the government will tax it as though it were part of your ordinary income. You will have to list all applicable awards on your annual tax return statement and pay tax on in the amount of your personal income tax rate. Work with a tax specialist if you have a particularly large or complex personal injury settlement. Your attorney can also help you understand the specific tax repercussions of your settlement or jury verdict.