If you have a personal injury suit, contract dispute, or other legal issue, reaching a settlement may be easier than going to court. However, the IRS will sometimes tax money you receive from a settlement payment.
If you owe back taxes, the IRS can even take your settlement check to offset unpaid taxes. We’ll discuss different types of legal settlements and what you need to know about how the IRS taxes settlement payments.
What are the Types of Legal Settlements?
A legal settlement is an agreement between parties involved in a lawsuit that is made without having to go to court. Typically, settlements are a payment from one party to another related to personal injury, a broken contract, employment disputes, and more.
Here are some examples of common legal settlements and how the IRS taxes them:
Breach of Contract
Violations of contract terms and conditions. You will pay IRS taxes for all breach of contract settlement money received.
Work disputes such as discrimination, harassment, and wrongful termination. Like breach of contract settlements, you will pay IRS taxes for all employment settlement money received.
If you were also awarded compensation for emotional distress or pain and suffering, the IRS will tax this money too.
Physical injuries or illnesses. In most cases, you won’t pay IRS taxes for personal injury settlements you receive for emotional distress, medical, and pain/suffering.
However, the IRS will tax any punitive damages included in a personal injury settlement.
Deaths from misconduct and/or negligence. Most wrongful death settlement money received won’t be taxed by the IRS. Just like with personal injury, however, you will pay taxes for the punitive damages portion of a wrongful death payment.
Do I Pay Taxes on Money from a Legal Settlement?
As we discussed in the section above, whether you pay taxes to the IRS for settlement money depends on both the type of legal settlement and type of compensation you received.
For example, the IRS allows personal injury tax exemptions for settlements that cover costs of physical injuries and illnesses, like medical bills and lost wages.
However, the IRS in these cases can tax the portion of a settlement unrelated to an injury or illness, like punitive damages.
How Do I Report Legal Settlement Amounts on My Tax Return?
IRS reporting requirements vary by settlement type and the amount.
Here are some basic guidelines to keep in mind:
- Form 1099-MISC: If your settlement amount is $600 or more and the proceeds are considered taxable, the entity paying you must send you Form 1099-MISC. This form reports the settlement amount you need to include on your return. If you have an employment settlement with back wages paid, those should show on your W-2.
- Form 1040: Your settlement type determines which section you fill out on your Form 1040. For example, personal injury settlements are reported on Schedule 1 and employment settlements are reported on either Schedule C or Schedule E.
Can I Deduct Legal Costs from a Settlement Case When I File Taxes?
The IRS taxes settlements on total amount received. There’s no deduction for attorney fees. This means that if you settle for $100,000 and owe the IRS taxes on that amount, you will be taxed on $100,000, even if you had to pay $20,000 to lawyers.
Will the IRS Take My Settlement Check If I Owe Back Taxes?
If you owe the IRS, they can take some or all of your settlement money to offset your tax debt. However, if you’re already on a payment plan for unpaid taxes, the IRS may choose to not seize your settlement.
How Can I Resolve My Back Taxes to Keep My Settlement Money?
Here are some of the ways to resolve your back taxes with the IRS so you can keep your full settlement check:
- Installment Plans: An installment agreement with the IRS allows you to pay off what you owe in smaller monthly payments until your full tax debt is settled.
- Offer in Compromise: OIC is an IRS tax relief program that allows you to settle your tax debt for less than the full amount owed. You submit an offer for the IRS to consider and they’ll review your financial situation to determine whether to accept this reduced amount as a compromise.
- Currently Not Collectible: If you can prove that paying any amount of your tax debt will contribute to financial hardship, the IRS may temporarily suspend collections.
Understanding the tax implications of a legal settlement can help you avoid a big tax bill when filing your return. We can guide you on how to minimize taxes on money you receive from a legal settlement or help you set up an IRS payment plan if you owe back taxes and don’t want the IRS to take your settlement money.
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