How to Avoid Paying Taxes on a Lawsuit Settlement

Winning or settling your lawsuit can be exhilarating. After you’ve received the settlement money and paid attorney fees, most people assume that the rest is theirs to keep. However, some settlements are subject to taxes. And, unfortunately, many people don’t realize it until tax time the following year, after much of the money has been spent. To avoid a nasty, unexpected tax bill, this article will show you how to reduce or eliminate the likelihood that you’ll have to pay taxes on a lawsuit settlement. If you suddenly come into a large amount of money, work with a financial advisor to make the wisest of your windfall.

Factors Affecting a Lawsuit Settlement

According to Internal Revenue Code Section 61, all payments from any source are considered gross income unless a specific exemption exists. When you win a settlement, it can be difficult to know whether or not your award is taxable without analyzing the details. This list highlights nine common factors that determine taxability:

Physical injury or sickness: Settlements for physical injury or sickness where you’ve demonstrated “observable bodily harm” are not considered taxable by the IRS.
Emotional distress may be taxable: You’ll owe taxes on awards for emotional distress unless the distress originated from the injury or sickness caused by the accident.
Medical expenses: Awards for medical expenses are not taxable as long as you didn’t deduct related medical bills on the prior year’s taxes. If you deducted them last year, then you’ll pay taxes on that amount this year under the IRS “tax benefit rule.”
Punitive damages are taxable: Some judgments and settlements include an award for punitive damages against the defendant. These damages can provide a substantial payout to the plaintiff. The entire punitive damages award is taxable, which can lead to hefty taxes.
Contingency fees may be taxable: If your settlement is non-taxable, legal fees won’t affect your taxable income. Accident and personal injury cases, like a slip-and-fall or worker’s compensation case, are excluded. However, for taxable settlements, you may owe taxes on the full settlement, even when the defendant pays your attorney directly.
Negotiate the amount of the 1099 income before you finalize the settlement: Before you sign the settlement agreement, define whether or not the defendant will issue a Form 1099 or not. If they plan to issue one, negotiate the 1099 income to be a smaller number than your actual settlement amount.
Allocate damages to reduce taxes: During settlement negotiations, you can negotiate to allocate a larger portion of the settlement to non-taxable award categories. For example, increase the award related to physical injuries and illness and decrease amounts related to emotional distress.
Capital gains instead of ordinary income: Depending on the nature of your claim, you may be able to treat a portion of your settlement as capital gains. If you’ve sued over damage to your home or business factory, you may be able to classify the settlement as capital gains. Alternatively, your settlement might qualify as a recovery of tax basis, which is not counted as income.
Spread payments over time to avoid higher taxes: Receiving a large taxable settlement can bump your income into higher tax brackets. By spreading your settlement payments over multiple years, you can reduce the income that is subject to the highest tax rates.

Bottom Line

When you receive a settlement, there are numerous factors regarding the litigation itself as well as the state you are in that determine whether or not you’ll owe taxes on that amount. Because there are so many nuances, we recommend that you speak with an attorney and tax advisor to determine which rules apply to your specific situation. When you speak with these professionals, you may learn how to avoid paying taxes on a lawsuit settlement and keep more of the money for yourself.

Tips on Taxes

Receiving a settlement can be life-changing and a solid step towards addressing a bad situation. This money can set you financially for life if you can invest it wisely. A financial advisor can help you create a plan to grow your money wisely to meet your needs and goals. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Paying taxes is an obligation for every investor, whether you invest full-time or as a supplement to your paycheck. However, it can be a challenge to forecast what those taxes will be. Our income tax calculator helps you estimate your taxes owed based on your income, location, filing status, and basic deductions.