When resolving litigation, tax planning should always begin before settlement agreements are executed; otherwise, you risk losing money. With the help of an experienced tax professional, you can discover substantial opportunities to structure the litigation’s tax impact in your favor.
How are Settlement Proceeds Taxed?
First, one must consider the applicable statutory framework to understand income tax consequences resulting from settlements. Internal Revenue Code (IRC) §61 has a very broad reach, stating that gross income includes “income from whatever source derived,” unless otherwise exempt. Under IRC §104, a limited exclusion exists in the context of amounts received pursuant to certain personal injury claim resolutions. Note that the exclusion is specifically limited to damages, other than punitive damages, received “on account of a personal physical injury or physical sickness.”1
A. The Origin of Claim Test
You have to pay taxes on income from legal settlements because it is considered part of your yearly gross income. However, there are exceptions to this rule, especially in cases involving personal injuries. This is important to know because a settlement agreement should be drafted carefully with tax payments in mind.
Settlements compensating for physical injuries or physical sicknesses are tax exempt. This applies to settlements in many personal injury cases but could also apply to any case that brings a claim for damages based on a physical injury or sickness. This means that the nature of the claim can influence whether settlements are taxed. Most punitive damages are taxed as are compensatory damages. This includes damages for an injury or sickness that is considered emotional. However, damages paid for emotional distress are not taxable if they are the result of a physical injury or sickness. For example, if a physical injury on the job results in emotional distress later, the compensation for the emotional distress would not be taxed as long as the settlement agreement is clear. Punitive damages are taxed unless you receive them as the result of a wrongful death judgement in a state that ONLY allows punitive damages in wrongful death cases.
If your claim requests damages to compensate for a physical sickness or injury, the settlement you receive may be tax exempt. When an agreement indicates that a portion of a settlement is to compensate for a physical sickness or injury, then that portion of the settlement is tax exempt. For this reason, damages paid for a physical injury or sickness should be specifically stated in the agreement to ensure they are tax exempt. Without a carefully drafted settlement agreement, issues could arise between parties or with the IRS when it comes time to pay taxes on the income from a settlement.
There are many reasons to keep tax payments in mind when drafting a settlement. The IRS will examine the intent of the payor if it is not specifically stated in the agreement. With this in mind, settlements should be drafted to specifically indicate which damages are compensating for which injuries to avoid disputes between parties or the IRS.
In summary, a settlement agreement should clearly indicate if any part of the settlement is compensation for a physical sickness or injury to ensure that part of the income from the settlement is tax exempt. If you need assistant with any tax issues, please contact Frost Law’s tax team at (410) 497-5947 or fill out our online form.
Footnotes
- IRC §104(a)(2).
