A lot of people think, “If I win money in a case, do I have to give some to the IRS?” The answer is; sometimes yes, sometimes no. It really depends on what kind of money you’re getting.
The IRS doesn’t just look at the big number of your settlement and then get greedy. No. They instead break it down into types of compensation, and each type has its own rule.
The rules come from something called IRS Section 104. Don’t worry, you don’t need to read the whole tax code. Here’s the simple version: if the money is for physical injuries or sickness, it’s usually not taxed. If the money is for things not tied to physical harm, it might be taxed.
What’s Taxable in a PI Settlement
Here are the types of settlements in a PI case that could be taxable:
Lost Income
If your settlement pays you for wages you missed because of your injury, then the IRS treats it just like normal wages. Wages are always taxed, so this money gets taxed, too. Federal tax, and usually state tax as well.
Pain and Suffering (Sometimes Taxed, Sometimes Not)
There’s a slight complication here. Your pain and suffering settlement is usually:
- Not taxed if your pain and suffering are connected to a physical injury. Like if a car accident broke your arm and you’re also depressed because of the injury, that’s linked to the physical injury. Not taxed.
- Taxed if your pain and suffering are not tied to a physical injury. Like if you’re suing for emotional distress from being fired, but your body isn’t injured. That’s taxed.
So always look at what caused the pain. If it started with a physical injury, you’re safe. If not, the IRS wants its share.
Attorney Fees (Complicated)
If the money you got is taxable, then the fees paid to your lawyer are also considered taxable. Even if the money went straight to the lawyer. So you might need to report the full settlement amount, not just what you personally received.
If the settlement itself is not taxable (like medical bills), then the fees connected to that part are not taxed either. This part gets confusing, so most people check with a tax professional.
Interest
Sometimes settlements take forever. If the money earns interest while you’re waiting, the IRS treats that as regular interest income. So yes, it’s taxed.
What Parts of Your Settlement Are Not Taxable?
Here’s what the IRS can’t tax:
Medical Bills
If the money is just to pay back your hospital bills, surgeries, medicine, or doctor visits, that’s not income, so the IRS doesn’t tax it.
But there’s one catch: if you already used those bills to get a tax deduction in a past year, then when you get paid back, the IRS calls that double-dipping. In that case, that part could be taxed.
Property Damage
If someone wrecks your car, your house, or anything else you own, the settlement money to fix or replace it is not taxed. But here’s the rule: if they pay you more than the property was worth, that extra part is taxable.
Workers’ Comp
If you’re injured at work and you’re getting workers’ compensation, you don’t pay taxes on it. That includes medical coverage, lost wages under workers’ comp, and any benefits tied to it.
But if you sue a third party for the same injury and get extra money, then the tax rules from above apply, depending on the types of compensation.
Do You Report It to the IRS Anyway?
Yes. Even if your settlement is mostly tax-free, you might still get a Form 1099-MISC. The IRS wants to see the full amount. Then you show which parts are taxable and which aren’t. That way, you’re being transparent, and you don’t risk getting flagged later.
Summary: What’s Taxed and What’s Not
- Medical bills (not taxed unless you already deducted them)
- Pain and suffering linked to physical injuries (not taxed)
- Property damage (not taxed unless you get more than it’s worth)
- Workers’ comp benefits (not taxed)
- Lost income (taxed)
- Pain and suffering not tied to physical injury (taxed)
- Punitive damages (taxed)
- Interest on settlement (taxed)
- Attorney fees tied to taxable parts (taxed)