Taxability of Lawsuit Settlement Awards

Blue man carrying the words tax on his back
Personal Injury and Medical Malpractice Lawyers who negotiate settlements need to consider the tax issues affecting their client when drafting both the complaint and the final settlement agreement.

Payments received as compensation for physical injuries are free of federal income tax and Pennsylvania Income tax. Such is the case even if the monies received are from a court-ordered award or an out-of-court settlement. It also matters not if the payment is in a single, lump sum or paid in installments. However, you cannot deduct attorney fees incurred to collect a tax-free award or settlement for physical injury.

Some additional tax rules to consider in determining if the award is taxable:

  • Compensation for emotional distress arising out of a physical injury is tax-free because the distress is considered part of the physical injury or illness.
  • Amounts received under a disability policy where you paid the premiums are not taxable as long as you did not deduct the premiums on your past tax returns. If you did deduct the premiums then the amounts received are taxable as ordinary income.
  • Amounts received for medical expenses will be tax-free unless the individual claimed a medical expense deduction for such expenses that are later reimbursed from the settlement. Even when there is no specific allocation, the settlement is deemed to include a reimbursement for such expenses up to the amount of those expenses and includible in income.
  • Claims for taxable lost wages or lost profits will generally be reported as ordinary income while claims for injury to a capital asset will be taxable as a recovery of basis and capital gain.
  • Front pay or back pay will be characterized as “wages” for purposes of payroll tax withholdings and subject to federal income and payroll tax.
  • Interest received on the award or settlement will be taxable.
  • Awards to effectively punish the wrongdoer such as punitive damages are generally taxable even when paid as a result of a physical injury.
  • Payments for non-physical injuries (i.e. discrimination, wrongful termination, emotional distress not caused by physical injury, invasion of privacy, libel, harassment, etc.) will be taxable. Such amounts for emotional distress are not treated as a physical injury or physical sickness, except to the extent those damages attributable to the emotional distress were used to pay for medical care.
  • If part of your award is tax-free (i.e. physical injury) and the balance is taxable (i.e. interest, punitive damages, non-physical injury, etc.) the recipient is required to report the entire gross amount of the taxable portion of the award as taxable income. No reduction is made for the related legal fees. The proportionate attorney fees applicable to the taxable portion may be deducted as a miscellaneous itemized deduction (i.e. multiplying the total fees by a numerator of the taxable portion over the denominator of the total amount of the award or settlement). Unfortunately, such “miscellaneous itemized deductions” are only deductible in excess of 2% of Adjusted Gross Income (AGI) and they are completely disallowed for AMT (Alternative Minimum Tax) purposes. Thus, the injured person’s actual deduction for the attorney fees related to taxable awards may actually yield little or no tax benefit if their adjusted gross income exceeds approximately $180,000.
  • There are two noteworthy exceptions to this when part of your award is taxable and part is tax free. One is that legal fees will be deductible “above the line” as a Schedule C deduction when the lawsuit arises entirely from the taxpayer’s business. The second will occur for legal fees incurred in certain types of unlawful discrimination cases (i.e. whistleblower rights, civil rights, labor/employment rights, etc.). These can also be deducted “above the line” and not as a “miscellaneous itemized deduction” on schedule A.
  • Structured settlements for physical injury awards are where payments are received over a specified period of time rather than in a lump sum can escape taxation. If done properly, a structured settlement may convert “earnings” (imbedded accumulated interest) which otherwise might have been taxable to tax-free.

If you or your lawyer has any questions about the taxability of your lawsuit settlement call Gregory Spadea of Spadea & Associates, LLC in Ridley Park at 610-521-0604.
