Tax Planning Alert: Is Your Lawsuit Settlement Taxable?

If you’ve recently received a legal settlement or court award, or expect to, it’s important to understand the potential tax consequences. Not all lawsuit proceeds are treated equally by the IRS. Depending on how your award is structured, you could face unexpected tax liability, or worse, miss opportunities for tax savings.

As your trusted tax advisors, we want to help you stay ahead of these issues so you can make informed financial decisions and protect your long-term strategy.

Understanding What’s Taxable

The IRS generally breaks legal settlements into two main categories:

1. Taxable Awards:

• Compensation for lost wages, lost profits, or back pay is treated like earned income — and are subject to both income and payroll taxes.

• Punitive damages, breach of contract, and awards for emotional distress not tied to physical injury are also taxable.

• Settlements in discrimination or employment-related cases are often fully taxable unless tied to documented physical harm.

2. Non-Taxable Awards:

• Awards for personal physical injuries or physical sickness (like accident-related medical issues) are generally excluded from your reported income.

• However, the injury must be physical in nature. Emotional harm alone, even with real consequences typically does not qualify for tax-free treatment.

Mixed Settlements = Mixed Tax Consequences

Many legal settlements involve multiple types of damages. For example, a claim might include compensation for medical costs (non-taxable), back pay (taxable), and emotional distress (potentially taxable).

Another common issue: attorneys’ fees. Even if your legal fees are paid directly from the settlement, you’re often taxed on the full gross amount, not just what ends up in your pocket. This can significantly affect your tax planning and liquidity.

Why Strategic Tax Planning Matters

Language within a settlement agreement can influence how the IRS classifies the proceeds and ultimately what’s taxable. In some cases, it may be possible to structure an agreement so more of the award qualifies as non-taxable physical injury compensation.

Before signing or finalizing any settlement, it’s wise to consult with your tax advisor. We can help with:

• Reviewing and assessing the tax treatment of each part of the award

• Coordinating with your attorney to structure the settlement more tax-efficiently

• Planning for estimated tax payments, if needed

• Ensuring accurate reporting on your tax return

Final Thoughts

A lawsuit settlement can bring relief but can also carry financial complexity. Missteps can lead to missed planning opportunities or even IRS scrutiny.

If you’ve recently received a settlement or expect to, let us help you review the agreement to plan accordingly. We’ll make sure your tax and financial strategy aligns with your goals and keep you compliant.

Have a settlement you’d like us to review? Contact our office — we’re happy to help!