You must be wondering about the different factors governing lawsuit settlements. There might be several reasons for which you get a fair financial offer from a lawsuit.
There can be compensation for the losses due to physical injury, different types of emotional stress, punitive damages, or damages from other injuries. It is important to be aware that as a general rule settlements are taxable, even if there are some exceptions. Generally, any money you receive from a lawsuit or other legal remedy is taxable.
However, there are some exceptions. The Internal Revenue Code (IRC) Section 104 says that some of this money may be excluded from your taxable income.
Why Are Lawsuit Settlements Important?
A settlement is made when one party agrees to give up their right for a more appealing option. In the case of a lawsuit, this means that one or more of the involved parties settles on an agreement rather than continuing with the court proceedings.
A settlement is usually preferable to all sides involved, as it allows them to avoid further legal fees and associated costs while avoiding the risk of an unfavorable ruling in court. Lawsuit settlements are important because they allow parties to agree on a mutually-beneficial resolution, rather than allowing lawsuits to drag on for years with unpredictable results.
The costs associated with litigation can be astronomical, and not just in terms of legal fees. A single case may require hundreds of thousands of dollars just to cover the costs of expert witnesses alone.
Add on additional funds for travel & lodging expenses incurred by witnesses who must appear in court, and the expenses associated with trial begin to look more like an inescapable black hole than an expenditure.
At this point, it becomes extremely difficult to predict what the outcome of a case may be. Even with clear-cut evidence in favor of one party, there is still no guarantee that they will win their lawsuit when heard before a judge or jury.
A lawsuit settlement allows parties to avoid this unpredictability. By coming to a mutual agreement, the two sides are able to avoid these steep expenses while also avoiding the risk of ending up with nothing at all if their court case isn’t successful.
Different Types of Lawsuit Settlements
There are usually 2 primary types of lawsuit settlements: lump sum, and structured settlement.
A Lump Sum is an amount paid all at once in exchange for the total settlement agreement. For example, if you settle with the defendant for $30,000 before your court case reaches trial then that will be your settlement amount.
A structured settlement is when a plaintiff receives a portion of their settlement amount each month or each year, usually over many years or even decades.
For example, if you settle with the defendant for $30,000 and they agree to pay you in annual installments of $2000 beginning whenever you turn 25 then that will be your settlement amount.
How Are Lawsuit Settlements Taxed?
As every case is different, so will be the facts and circumstances for every case. The Internal Revenue Service (IRS) states that the taxes on settlements are generally based on the origin of the particular claim, the reason for the claim, and other factors that will form the basis of the settlement.
There can be a possibility that there is more than one type of damage claim that may arise from an injury. Some may be taxable while others are not. Lawsuit settlements are generally considered taxable income by the IRS. However, not all settlement payments are taxed the same way.
For example, compensatory payments (payments awarded for lost wages or medical expenses) are considered ordinary income and are subject to your marginal tax rate (plus local taxes if applicable).
On the other hand, damages paid out in lieu of lost wages aren’t taxable; however, this doesn’t apply to other types of damages (e.g., damages for emotional distress).
As per Section 104 of the tax code, if the origin of the claim that arises is from physical injuries or sickness, the settlement will be tax-free. It is important to remember that a person cannot use a similar tax break two times.
For settlements coming from a claim with an origin coming from non-visible injuries (e.g., slander, defamation, sexual harassment), the same rule will not apply. Although emotional stress is quite different from non-visible injuries, it is handled in a similar manner.
According to the Internal Revenue Service (IRS) lawsuit settlement taxable income Section 61, all income is taxable until an exception from another section of the code applies. Section 61 is reserved for the amounts that are expected from the lawsuit’s settlements and various other legal remedies.
The common types of compensation that are always taxable include:
- Interest received on monetary awards;
- Payments made for lost profits or lost wages;
- Damages for copyright infringement or patent infringement or some breach of contract;
- Money that is to be received for settlement of pension rights.
To thoroughly understand the intricacies of the law regarding taxability of lawsuit settlements and how it interacts with your insurance policy, you may consider consulting an experienced Tax Lawyer in Philadelphia to help you determine whether your lawsuit settlements are taxable or tax-exempt.
Are Personal Injury Settlements Taxable?
The general rule, as per state and federal laws, personal injury settlements are non-taxable. This means that the settlement will be excluded from the income section of your tax forms.
When you sustain physical injuries in any type of personal injury case, the IRS will consider the compensation for your damages as not taxable. However, this rule has exceptions. In personal injury settlements, punitive damages are always taxable, which is why they are often separated from compensatory damages.
Which of the Personal Injury Settlements Are Non-Taxable?
As mentioned above, as a general rule, personal injuries lawsuit settlements are not-taxable. In Pennsylvania, some of the most common personal injuries claims include:
- Dog bites
- Medical Malpractice
- Motor vehicle accidents
- Workplace and construction injuries
- Wrong deaths
Other personal injuries that are non-taxable are premises liability, defective medications, and product liability. However, it is important to remember that every case is different in its own way and whether the case is taxable or not depends on the particular personal injury case.
Are Car Accident Settlements Taxable?
Car accident lawsuit settlements are taxable, but only under certain circumstances. For example, damages paid out for emotional distress or medical expenses due to a car accident would be considered taxable income according to the IRS and include them in your gross settlement amount before calculating your tax liability.
Damages paid in lieu of lost wages due to a car accident, on the other hand, are not taxable. If your injury was caused by another driver’s negligence, you may be entitled to damages for lost wages due to missed work. If this is the case, your car accident lawsuit settlement would not be taxable.
However, if your settlement does not constitute lost wage damages or otherwise fails to meet IRS guidelines for non-taxable income, you will have to pay taxes on the total amount of your gross settlement minus associated costs.
The best way to determine whether your car accident settlement is taxable or not would be to consult with an experienced tax professional. The above guidelines are meant for general reference only and cannot replace the proper tax advice from a tax professional.
How Do I Know What Settlements Are Non-Taxable?
If you are the plaintiff in a lawsuit, your winning settlement will likely be considered ordinary income. This means that it will be taxed at your marginal tax rate (plus local taxes if applicable). However, there are ways to minimize the tax burden associated with your lawsuit settlement.
For example, if you are the plaintiff in a lawsuit where damages awarded to you fall under certain categories (e.g., personal injury/physical sickness), these parts of your settlement may be tax-free.
Again, not all damages are tax-free; an accountant and experienced Tax attorney could let you know which parts of your settlement should be considered non-taxable. Our lawyers here, in Philadelphia, at the Law Offices of Samuel Fishman can help you determine which settlements are taxable and which are not. Contact us today!