Can the IRS Take My Settlement Money? (2024)

FAQs

Can the IRS Take My Settlement Money? ›

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.

Settlement money and damages collected from a lawsuit are considered income, which means the IRS will generally consider that money taxable. However, personal injury settlements are an exception (most notably: car accident settlements and slip and fall settlements are nontaxable).

Taxability of Personal Injury Settlements in California

The tax rate is based on the highest marginal tax rate in the state, which is currently 13.3%. There are some exceptions to this general rule. For example, if you settle a workers compensation claim, the settlement is not subject to taxation.

To help protect your awarded settlement, it's vital that you separate that money from all other wages earned. This means depositing your money into a separate segregated account and never depositing any other money into that account. If you mix your money, it removes the exemption for this compensation.

Negotiating a settlement directly with the IRS may also be an option in certain situations. This involves proposing a lump sum payment that is less than the total amount owed. Keep in mind that the IRS is generally more inclined to consider this option if there is doubt about the collectibility of the full debt.

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.

The general rule regarding taxability of amounts received from settlement of lawsuits and other legal remedies is Internal Revenue Code (IRC) Section 61. This section states all income is taxable from whatever source derived, unless exempted by another section of the code.

California, similarly to the IRS, does not tax the entire personal injury settlement you receive. Only portions that are considered compensation for economic losses are taxed by California. The most common occurrence of California taxing settlement awards is for punitive damages.

Generally, the IRS will take 25 to 50% of your disposable income. Disposable income is the amount left after legally required deductions such as taxes and Social Security (FICA). There are exceptions to this rule, however, that could protect some or all of your earnings from wage garnishment.

Is pain and suffering settlement taxable IRS? ›

These are non-economic damages that can be recovered in addition to your monetary or economic losses. The compensation you receive for your physical pain and suffering arising from your physical injuries is not considered to be taxable and does not need to be reported to the IRS or the State of California.

For example, compensatory awards and judgments for “personal physical injuries or physical sickness” are free from federal income tax under the tax code. This includes amounts received in a lawsuit or a settlement and in a lump sum or in installments.

The party that pays a taxable settlement or judgment to the injured party and/or their attorney will issue a Form 1099-MISC, Form 1099-NEC, or W-2 to report the settlement. In some cases, the claimant and attorney are issued separate 1099s reporting the same settlement dollars.

6 years - If you don't report income that you should have reported, and it's more than 25% of the gross income shown on the return, or it's attributable to foreign financial assets and is more than $5,000, the time to assess tax is 6 years from the date you filed the return.

Unless you can clearly demonstrate through documentation and allocation in the settlement agreement that some of the money falls into a category of settlements that aren't taxed, it's usually assumed that all of the settlement money needs to be reported as taxable income.

One-time forgiveness, otherwise known as penalty abatement, is an IRS program that waives any penalties facing taxpayers who have made an error in filing an income tax return or paying on time. This program isn't for you if you're notoriously late on filing taxes or have multiple unresolved penalties.

You're required to report it as other income. Even if you don't receive a 1099-C, you're still required to report the amount of your forgiven debt on your tax return.

Emotional distress.

If a victim is awarded damages solely for emotional or mental distress, the damages are subject to taxation by the federal government.

Reporting trustee fees by a trust on a Form 1099-Misc is not required. The 1099-Misc is for payment of services performed in a trade or business by people not treated as employees.