Are Court Settlements Taxed | RJS LAW | Tax Attorney | California (2024)

FAQs

Are Court Settlements Taxed | RJS LAW | Tax Attorney | California? ›

In California, personal injury law allows victims to recover additional settlements known as punitive damages. These awards occur when the grievance, injury, or damage results form an egregious act of the defendant. These settlement dollars are always considered taxable.

Once you pay your attorney's fees and legal costs out of your award or settlement, you will be able to keep the remainder minus any taxes that might be owed for damages for your lost wages, punitive damages, or interest.

Settlement money and damages collected from a lawsuit are considered income, which means the IRS will generally consider that money taxable. However, personal injury settlements are an exception (most notably: car accident settlements and slip and fall settlements are nontaxable).

In short, if you receive money from a legal settlement and you believe you shouldn't pay taxes on it, it's your responsibility to prove to the IRS why it should be tax-free. The most common types of tax-free settlements are those received as compensation for personal physical injuries or physical sickness.

For example, payments made to compensate a plaintiff for actual damages or harm caused by the defendant's action generally are deductible. However, some settlement payments or legal fees may be characterized as capital expenses if they are incurred in connection with the acquisition of a capital asset.

Section 104 excludes settlement money received for personal physical injuries and physical sickness. This means that money from the settlement for medical costs, lost wages, pain and suffering, and other losses from physical harm do not need to be reported as income.

The federal government does not tax your settlement money since the funds received are intended to compensate you for losses that you endured. This is true both for actual economic damages (such as medical bills and lost wages) and for non-economic damages such as for pain and suffering and emotional distress.

The party that pays a taxable settlement or judgment to the injured party and/or their attorney will issue a Form 1099-MISC, Form 1099-NEC, or W-2 to report the settlement. In some cases, the claimant and attorney are issued separate 1099s reporting the same settlement dollars.

Legal settlements that are taxable (including previously deducted medical expenses related to physical injury or illness) are entered as miscellaneous (other) income. Interest earned on settlements is taxable income and should be entered as a Form 1099-INT.

In General, Wrongful Death Settlements Are Not Taxable

Usually, wrongful death settlements are not considered income, which means that they are not taxable.

Who pays taxes on lawsuit settlements? ›

According to the Internal Revenue Service, settlement funds must be included in federal income for tax filing purposes unless they are specifically exempted by the tax code. The good news is that any damages you receive based on physical injuries are exempted and don't have to be included as taxable income.

If you're expecting a tax refund but have concerns about creditors garnishing it, you may be worrying too much. Federal law allows only state and federal government agencies (not individual or private creditors) to take your refund as payment toward a debt.

Investors can avoid taxes on a lump sum pension payout by rolling over the proceeds into an individual retirement account (IRA) or other eligible retirement accounts.

Typically, the only closing costs that are tax deductible are payments toward mortgage interest, buying points or property taxes.

Whether you are able to deduct professional services fees depends on the purpose of the service. For example, legal and accounting services that are part of your business' “ordinary and necessary” expenses can be deducted. Personal legal expenses cannot, however.

Interest on Settlements: Any interest accrued on the settlement amount is considered taxable income. Punitive Damages: Aimed to punish the defendant, these exceed compensatory damages and are taxable. Emotional Distress Not Stemming from Physical Injury: If it's not related to a physical injury, it's taxable.

The IRS requires that you report payments to your attorney for legal fees on Form 1099-NEC if the payment(s) total $600 or more. When you pay someone else's lawyer in regard to a settlement, this payment should be reported on 1099-MISC if it totals $600 or more.

Payments to attorneys may require both forms. Gross proceeds paid to an attorney, such as services related to a specific litigation matter should be reported on Form 1099-MISC whereas attorneys' fees, such as for general business matters, should be reported on Form 1099-NEC.

Under this legislation, plaintiffs are still required to pay taxes on the entire gross recovery, which includes their attorney's fees. Unfortunately, they cannot deduct those attorney fees on their tax returns, creating the “Plaintiff Double Tax Trap.”

The insurance company will typically send a check to your attorney. If your attorney has received notice of medical liens, they will pay those before sending you the remainder of your money. If you have received additional medical bills, you will be responsible to pay those out of your settlement check.