Are Out-Of-Court Settlements Taxable?

February 14, 2020

Disclaimer: This post is informational only and we do not have tax attorneys on staff. If you have questions about your tax liability, please seek a qualified professional.

If you have received settlement through a lawsuit against another person, or if you anticipate receiving one in the near future, you will likely have several questions about how that settlement will be taxed. After all, taxes are generally an issue that nobody can escape. Because most lawsuits are settled out-of-court, it is reasonable to ask whether an out-of-court settlement is taxed differently than a jury verdict settlement. Rest assured, the US Internal Revenue Service (IRS) has rules regarding this issue.

Personal injury lawsuit settlements are generally not taxable

If you file a lawsuit against someone who has caused a personal physical injury or illness, any damages that you receive in a settlement for compensation are generally not taxed, whether they are jury verdicts or out-of-court settlements. This includes any compensation you receive for medical bills, lost wages and benefits, pain, suffering, and emotional distress. Whether you receive your settlement for these damages in one lump sum payment or installments, you should not be taxed.

What about punitive damages and taxes?

In some personal injury lawsuits, punitive damages are awarded. As the name suggests, punitive damages are designed to punish the wrongdoer. These damages send a signal that the type of behavior that caused the injury is unacceptable and should not happen again in the future.

Because punitive damages are not intended to compensate a person directly for their loss, they will face taxation. If you are awarded punitive damages for your case, your attorney will likely let you know that the award will face taxes, unlike the other types of compensation you receive.

Are other types of settlements taxable?

Of course, personal injury lawsuits are not the only type of lawsuit that a person can file with the help of a Santa Ana personal injury attorney and receive compensation for. In cases of non-personal injury lawsuits, any award or settlement a plaintiff receives will generally be taxable as ordinary income. For example, a person could file a gender discrimination lawsuit against their employer or a lawsuit in order to collect back pay. The following items in these cases will count as ordinary taxable income:

• The interest on any award payment
• Payments for lost wages or benefits
• Any amount received for a settlement of pension rights
• Damages for breach of contract, interference of business operations, patent or copyright infringement
• Back pay and damages for emotional distress
• Any punitive damages awarded in these cases

What about attorney costs?

While not directly related to taxes, you will also be concerned about attorney fees. You should never enter into a client-attorney relationship without first coming to an agreement on how your attorney will be paid. In many cases, the attorney will charge by the hour. The client may also pay any costs that arise during a case.

However, for many personal injury and non-personal injury cases, an attorney will work on a contingency fee basis. This means that the client pays no legal fees until they receive compensation for their claim. The attorney will be paid based on a previously agreed-upon percentage of the final settlement or award.

You will still have to pay taxes on the amount of the award that goes to your Orange County personal injury attorney for non-personal injury awards, even though you will not be receiving that amount. For example, suppose you are awarded $100,000 after a discrimination lawsuit and have agreed on a 30% contingency fee with the attorney. This means that you will receive $70,000 out of the compensation and pay your attorney $30,000. However, you will have to pay taxes on the entire $100,000.