Our Blog

Are Out-of-Court Settlements Taxable?

The vast majority of personal injury claims settle outside of court. Very few reach conclusions by a jury verdict. While this may seem like an easier resolution for the parties involved, it is vital for a plaintiff who receives a settlement outside of court to acknowledge his or her financial obligations. After receiving an out-of-court settlement, the plaintiff will not only need to handle his or her attorney’s fees, but the IRS may also expect a portion of the settlement.

The attorneys at Walkup, Melodia, Kelly & Schoenberger have more than 50 years of experience with civil claims in California and have settled many cases outside of court for past clients. We understand that many settlement recipients worry about their tax obligation after a cash award. Depending on the type of damages involved in the case and the overall amount of the settlement, a recipient could face significant tax obligations. Our firm is available to help with complex settlement issues, so contact our personal injury lawyers today to schedule a free consultation with an attorney.

Settlements Outside of Court

When a legal matter arises between two private parties, settling outside of court often provides a speedier and less expensive resolution to the matter for everyone involved. Settling offers the plaintiff the opportunity to secure a recovery more quickly, albeit the settlement value of a given claim is likely lower than its potential trial value. On the other side, the defendant may offer more than he or she may have expected to pay in exchange for settling the matter quickly.

When two parties agree to a settlement, they very carefully scrutinize the damages involved in a claim and allocate an appropriate amount to each. Different types of damages have different tax implications following the passage of the Small Business Job Protection Act (SBJPA) of 1996, which added damages for personal physical injuries or physical sickness to the list of tax-exempt damages in an out-of-court settlement. Since businesses cannot legally suffer personal physical injuries, these tax-related distinctions only apply to settlements awarded to individuals.

Tax Treatment of Awards and Settlements

An out-of-court settlement usually involves several types of damages. The origin of those damages typically determines the tax treatment of the different types of awards. As a general rule, all damages related to personal physical injuries are tax exempt. For example, if a drunk driver hits a pedestrian and causes catastrophic bone fractures requiring surgery, all damages resulting from this severe injury would be tax exempt. However, there are limits for some types of damages.

Physical Injury or Sickness

There are several types of compensation a plaintiff could receive that would qualify as tax exempt. As long as a plaintiff’s damages resulting from a personal physical injury, it is possible for several types of proceeds to qualify for tax exemption.

  • Immediate and future medical expenses required for the treatment and rehabilitation of a personal physical injury or physical sickness.
  • Lost income from time spent in recovery, or lost earning potential if a catastrophic injury prevents returning to work at all in the future or resuming the same job.
  • Pain and suffering compensation is also exempt; however, while compensation for physical pain remains exempt, there is a separate formula for emotional distress.
  • Attorneys’ fees resulting from a personal physical injury would also qualify for tax exemption.

Ultimately, all damages resulting from personal physical injury or physical illness caused by a defendant do not qualify for taxation. A settlement recipient would generally not need to disclose these awards as part of his or her gross taxable income. However, some damages related to a physical injury or illness may qualify for taxation, specifically emotional damages and punitive damages.

Emotional Damages

Damages related to the direct treatment of personal physical injuries such as hospital bills, ongoing physical therapy, and compensation for physical pain involved with those injuries qualify as tax exempt. Severe injuries often result in psychological harm as well, and the SBJPA consider emotional distress damages as tax-exempt, but only up to the number of medical expenses the plaintiff sustained.

Following the previous example of the drunk driver and pedestrian, the injured pedestrian incurs $50,000 in medical expenses, but the jury believes he deserves much more than that for the intense recovery and temporary disability experienced after the accident. Only the first $50,000 of emotional damages would qualify as tax exempt. Any amount beyond the number of medical expenses for a personal physical injury would be subject to taxation.

Proving emotional damages is sometimes challenging, and the amount awarded generally falls to the judgment of the jury. A plaintiff’s attorney will generally look to expert witnesses who can testify in a professional capacity and inform a jury of the extent of psychological harm suffered by a plaintiff. Mental health treatment records and invoices for counseling and psychotherapy also help support a plaintiff’s position in this regard.

Punitive Damages

Some out-of-court settlements arise from situations involving defendants who acted beyond the scope of typical negligence or who were engaged in illegal activity at the time of the injury-causing incident. Some settlements arise from intentional torts, and those who commit such torts will likely face criminal prosecution regardless of whether they settle out of court with a victim or proceed to a civil trial.

Punitive damages exist to punish wrongdoing and are always subject to taxation. While a negligent tort generally will not lead to punitive damages, an intentional tort, or one committed knowingly and/or maliciously will lead to such damages. Continuing with the example of the drunk driver and the pedestrian, since driving under the influence is illegal the defendant would likely face criminal charges from the state and punitive damages in civil court. The jury awards the plaintiff an additional $100,000 in punitive damages and this entire amount would be subject to taxation.

The amount of punitive damages awarded generally depends on the financial status of the defendant; wealthier defendants generally pay much more in punitive damages than lower-income defendants. As a general rule, all punitive damages qualify for taxation, but some state laws may provide that punitive damages arising from a wrongful death do not.

Taxation on Judgment Interest

The court rules of most states provide that a plaintiff who receives a judgment will collect interest on that judgment until such time as the plaintiff can claim the judgment. For example, if a plaintiff receives a judgment on January 1, 2019, interest would begin to accrue on January 1, 2019, and continue until the plaintiff receives payment. The plaintiff may win at trial a year later on January 1, 2020. However, the defendant may file an appeal and delay a resolution for another year, finally paying the plaintiff on January 1, 2021. In this scenario, the interest accrued on the judgment between January 1, 2019, and January 1, 2021, would qualify for taxation.

Tax Bracket Obligations After Settlement

Another unexpected tax implication a plaintiff could face is moving into a higher tax bracket after receiving an out-of-court settlement. After paying all immediate tax obligations and legal fees, the remaining taxable award would qualify as gross income. If this is a substantial amount the plaintiff may enter a higher tax bracket, increasing his or her tax obligation for the next reporting year.

Penalties

If any portion of an out-of-court settlement qualifies for taxation, failure to pay taxes as required can lead to significant penalties. Generally, most legal issues pertaining to unpaid taxes from out-of-court settlements arise when award recipients and their legal representatives conclude that their legal proceeds do not qualify for taxation. Several potential penalties exist for failing to disclose tax-related award information or other pertinent details about an out-of-court settlement or an attorney’s failure to properly advise a client as to the taxability of their damages.

  • A Failure to File penalty may arise if a settlement recipient neglects to report the case award as taxable income as required by law.
  • A Failure to Pay penalty results when a settlement recipient acknowledges his or her tax obligation but fails to pay it accordingly or on time.
  • The Estimated Tax Penalty for Individuals exists for those who inaccurately estimate their tax obligation and pay less than they owe.
  • A Fraudulent Failure to File penalty results when a settlement recipient knowingly attempts to hide pertinent financial information to avoid paying taxes.

Penalties result from settlement recipients knowingly misrepresenting aspects of their case, such as the true value of their damages resulting from personal physical injury or physical sickness. It is possible for a settlement recipient to face one or more of these penalties without actually engaging in any knowingly illegal or fraudulent activity.

These penalties may also result from a taxpaying settlement recipient’s failure to question the judgment of his or her attorney regarding taxability of an out-of-court settlement and the damages therein. It is sometimes possible to resolve honest misinterpretations of a settlement recipient’s tax obligation by paying the amount owed, avoiding associated penalties.

Reducing Tax Obligation on an Out-of-Court Settlement

In some personal injury cases, a plaintiff may have multiple claims against the same defendant. If a plaintiff has an injury-related claim for a personal physical injury or illness and a non-injury-related claim against the same defendant for something like a breach of contract, the plaintiff should be very clear in his or her complaint when it comes to which claimed damages pertain to which claim. The damages from the injury-related claim would generally not qualify for taxation except under the previously specified circumstances; damages resulting from non-injury claims are almost always subject to taxation.

Walkup, Melodia, Kelly & Schoenberger offers legal representation in a wide range of civil claims for clients in Northern California. Settlement offers a speedier resolution to most personal injury claims, but obtaining a fair settlement for a personal injury and minimizing one’s tax obligations hinges on finding the right attorney to handle settlement negotiations.

Our attorneys have extensive experience with complex tax-related issues from out-of-court settlements. If you or a loved one need legal counsel for a complicated personal injury claim and worry about your potential tax obligations, contact Walkup, Melodia, Kelly & Schoenberger today and schedule a free case evaluation with one of our attorneys.