Are settlement funds taxed?

Many plaintiffs are surprised to find their settlement funds are taxable. The amount and whether or not the funds are entirely taxable is dependent on several key items. Lawyers who are responsible for providing clients with a settlement sheet, so it’s important to keep this in mind throughout the process.

Key items to note include the following^[1]:

• Punitive damages and the resulting interest are always taxable
• Taxes are typically charged at traditional income rates
• There are no taxes for recoveries for sickness and physical injuries, but symptoms of emotional distress don’t quality as physical. However, if those symptoms were caused by physical injury (i.e. a car accident) they could possibly quality as tax-free
• Taxes depend on the “origin of the claim” (evaluating what the reimbursement represents)

Additionally, for non-personal injury law settlements^[2], taxes are also generally charged for:

• Damages for copyright or patent infringement or breach of contract
• Settlements for pension rights if you didn’t pay into the plan
• Payments for lost wages

For law firms who earn fees from cases that result in settlement funds, these are taxable under traditional income laws.

References

1. Five Key IRS Rules on How Lawsuit Settlements Are Taxed
2. Tax Consequences of a Legal Settlement