The type of damages included within your settlement, how the damages were characterized as part of your overall claims process, and how the terms of your settlement agreement were established will determine your obligation to pay the Internal Revenue Service (“IRS”) and/or the State of Florida for taxes owed on your settlement.
Zoeller Law represents individuals throughout West Palm Beach and other areas of Florida who are dealing with complex issues surrounding their lawsuit settlement(s), including tax obligations associated with receiving such a settlement.
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561-689-8180Overview of the Federal Tax Code
Beginning with an easy-to-understand approach, the Internal Revenue Code (IRC) states that everything is income. IRC Section 61 defines Gross Income as including all income from whatever source. The IRS does not hesitate to assert that anything that may be considered income under the definition will be taxed.
There is one exception for settlement recipients, and it is defined by IRC Section 104(a)(2), which provides that any amount received through damages for personal physical injuries or physical sickness shall be excluded from gross income. In general, if your settlement meets these conditions, you will not have to pay federal income taxes on those funds.
Here are a couple of things you should know regarding these exclusions:
Punitive Damages do NOT qualify for the exclusion. Regardless of whether your underlying cause of action was based upon a physical injury, any punitive damages awarded will be taxable.
There is a significant distinction regarding whether the injury is described as “physical.” Prior to the enactment of Public Law 104-7, effective July 1, 1996, emotional distress claims had a stronger argument than they currently have for inclusion under this exemption. The amendment added the word “physical” to clarify that the injury must be physical in nature. The IRS has reinforced its position that the injury must be physical in nature when interpreting Section 104(a)(2) in Revenue Ruling 85-97 and Revenue Ruling 96-65.
Related Article(s)
Origin-of-Claim Doctrine
In addition to analyzing the type of damages included within a settlement, the IRS analyzes the reason behind the receipt of those damages. The IRS analyzes this reason using the origin-of-claim doctrine. As stated above, this doctrine is used by the IRS to determine whether any given settlement payment constitutes taxable income.
Simply put, whether your settlement is considered taxable is dependent upon whether your original lawsuit was brought due to some type of claim (i.e., automobile accident causing broken leg, etc.). If your lawsuit was brought in response to an automobile accident that resulted in your breaking your leg, then you should expect that your medical bills and damages for pain and suffering would not be taxable. However, if your lawsuit was brought in response to a discriminatory employment practice (i.e., wrongful termination), then you should expect that any medical bills or damages for pain and suffering that you receive as part of your settlement would be taxable.
Assuming that settlements are taxable absent evidence demonstrating otherwise is a significant presumption made by the IRS. It is essential to understand that the burden does not fall on the United States Government to demonstrate that you have received taxable income; instead, the burden falls upon you to demonstrate that the money you received did not represent taxable income.
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Damages Received Due To Personal Physical Injury Or Sickness
Generally speaking, if you receive compensatory damages that are directly related to a physical injury or illness sustained as a result of an incident (e.g., medical expenses, lost wages), then those damages will be excluded from gross income.
Examples of non-taxable damages include:
- Medical expenses associated with an incident of physical injury
- Lost wages caused by an incident of physical injury
- Pain and suffering damages related to an incident of physical injury
However, please note that there is an exception. There exists a tax benefit rule that states if you previously deducted medical expenses on your tax return and subsequently receive a settlement reimbursement for those same medical expenses, then the reimbursement is taxable. Essentially, you previously obtained a tax benefit from deducting those expenses. When you receive a reimbursement for those same expenses, the IRS wants you to give them back that tax benefit.
Worker’s Compensation Benefits
Workers’ compensation benefits are typically exempt from taxation. Workers’ compensation benefits cover medical costs and lost wages stemming from a job-related injury or illness. Both federal and Florida law recognize workers’ compensation exemptions.
Note: Punitive damages awarded in workers’ compensation cases are taxable. If you receive punitive damages (in addition to regular workers’ compensation benefits) as part of your claim, then those punitive damages are taxable and do not qualify for workers’ compensation exemptions.
Emotional Distress Damages Tied to Physical Injury
As mentioned earlier, emotional distress damages can be non-taxable provided that they stem from some form of physical injury. For example, assume you suffer a serious neck injury in an auto accident and develop post-traumatic stress disorder (“PTSD”). In that event, the emotional distress damages would likely be non-taxable because they stem from your prior experience sustaining physical injuries.
On the other hand, if your emotional distress damages arose solely from some other cause unrelated to physical injury (e.g., harassment at work), then your settlement is taxable.
Therefore, as seen above, determining what portion of your settlement is taxable requires a thorough review of each aspect of your claim.
However, if your damages include primarily emotional distress, and not any form of physical injuries, then the emotional distress damages will be considered taxable. More on that below.
Taxable Elements of a Settlement
Punitive Damages and Interest
Federal taxation generally treats punitive damage awards as income. This is true for all punitive damage awards, including those related to personal physical injuries. There could be one very limited exception if you have been awarded punitive damages solely under a wrongful death statute.
It’s possible that Florida wrongful death statutes might allow for the possibility of such a scenario (and therefore possibly exclude these amounts from being taxed). Therefore, do not assume this would be applicable in your case.
Interest on judgments before they are finalized and after they are finalized is taxable as regular interest income. In many settlements, there will be at least a partial amount that represents interest. That amount could be required to be included as taxable income. Your attorney fees may also present potential tax issues depending on how much of the settlement is taxable. You will want to review this with both your attorney and a competent tax professional.
Lost Wages and Other Employment-Related Settlements
To determine the impact of lost wages you may have experienced due to a physical injury, you will need to carefully examine the circumstances surrounding your settlement. Lost earnings or loss of earning capacity as compensation for a physical injury should be excluded from your federal taxable income. Any settlement payment for back pay, front pay, severance, wrongful termination, discrimination, wage disputes, etc., is generally considered taxable as wages and subject to payroll tax withholdings.
Settlements for discriminatory treatment and/or wrongful termination are generally taxable unless a proper allocation is made to identify which portion(s) relate specifically to compensating you for physical injuries or illness.
If you had a dispute resolved through a settlement in West Palm Beach or anywhere else in Florida, then most likely the entire settlement award is considered taxable income on a federal level.
Emotional Distress Not Resulting From a Physical Injury
Where a claim results in an award for emotional distress damages unrelated to a physical injury (e.g., defamation), such damages are taxable. While a person may experience real harm to their reputation and suffer serious emotional distress due to such harm, if no physical injury occurred, such emotional distress damages are not eligible for the exemption afforded for physical injuries.
Breach of Contract or Commercial Claims
Claims alleging breach of contract, commercial disputes, or property damage claims are generally taxable. Depending upon the nature of the claim, a settlement will be taxed as ordinary income or as capital gain. Capital gain rates may be preferable; however, determination of whether a settlement is taxable as ordinary income or capital gain depends upon the specifics of what the settlement resolved.
In general, if the settlement resolves a dispute regarding breach of contract or commercial relationship, the resolution will be taxed as ordinary income. Where a claim alleges breach of contract or commercial disputes, or property damage claims, the resolution thereof will generally be taxed as ordinary income.
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Another potential trap awaiting taxpayers who settle lawsuits is referred to as the “double tax” problem. The “double tax” problem arises where attorney fees constitute a percentage of the gross recovery of a lawsuit (i.e., contingency fees). The “double tax” problem occurs where an attorney receives a percentage of the gross recovery of a lawsuit (contingency fees) and the taxpayer reports as income both the gross recovery of the lawsuit and the attorney fee paid by the taxpayer. For example, if a taxpayer settles a lawsuit for $300,000 and pays his/her attorney a contingency fee equal to 30 percent ($90,000) of the gross recovery of the lawsuit (i.e., $300,000), then the taxpayer may report as taxable income both the gross recovery ($300,000) and the contingent fee paid to his/her attorney ($90,000).
While this appears to represent a double tax on the same dollars (the taxpayer paid $90,000 in attorney fees and receives $210,000 net), this is technically correct under current law. However, there are exceptions. Federal laws provide an above-the-line deduction for attorney fees in employment discrimination claims and certain civil rights claims. Such deductibility can significantly mitigate the impact of double taxation. However, such deductibility is limited to specific types of cases (i.e., employment discrimination claims and certain civil rights claims).
Prior to finalizing your settlement, consult with your attorney and tax adviser concerning how your attorney’s fee arrangement will be treated for tax purposes. Zoeller Law will work cooperatively with your tax professional to ensure your settlement is structured to take into account these issues prior to settlement.
Minimizing Taxes On Your Settlement
Documentation And Allocation Of Funds
A practical step that you can take to minimize your taxes on your settlement is to document exactly what each dollar of your settlement covers. Generally speaking, the Internal Revenue Code follows the allocation established by the parties to determine what is taxable versus what is non-taxable. If your settlement includes elements that are both taxable and non-taxable, documenting each element within your settlement agreement can protect you. Documentation of what each dollar is allocated towards is beneficial; failure to document allocations within your agreement provides little certainty and can leave you vulnerable to having funds deemed taxable by default.
Documenting each dollar covered in your settlement agreement can also protect you against adverse determinations by the IRS. Documentation is useful prior to signing your agreement; once signed, it can be difficult to fix allocations after the fact.
Structured Settlements vs. Lump Sum Payments
Lump sum payments give you access to all of your settlement monies immediately. That can be attractive, but it also means that you pay taxes on the full amount in one year and potentially put yourself in a higher tax bracket.
Structured settlements split up your payments over time. Structured settlements can help keep your taxable income down in any one year, making your marginal tax rate lower. However, structured settlements mean you cannot use all of your money at once. Whether that makes sense depends on your own financial situation. Consulting with a financial advisor can help you figure out whether structured settlements fit into your plan.
Trusts & Other Planning Vehicles
Plaintiff Recovery Trusts (and similar planning vehicles) may offer some benefit for large settlements. Depending on how they are set up, trusts may help defer or reduce taxes.
Please note that this area is complex and requires knowledgeable attorneys and tax professionals. If anyone recommends using a trust vehicle for your settlement without consulting experts in this area, proceed with caution. Using these tools with expert assistance can help protect you financially. Doing so improperly can cause additional issues than they resolve.
Changes To Tax Laws By The One Big Beautiful Bill (OBBBA) Of 2025
As previously mentioned, the One Big Beautiful Bill Act modified federal income tax brackets and standard deductions, among other things. Although the One Big Beautiful Bill Act changed nothing about whether a settlement is taxable or not, it did change tax rates applicable to taxable income.
If you relied on tax forecasts created prior to The One Big Beautiful Bill Act, update those forecasts now. Based on your settlement amount and income picture, the new marginal tax rates may affect what you actually owe.
Again, please seek advice from an informed tax professional in addition to communicating with both your attorney and tax professional about how your attorney fee arrangements will be treated for tax purposes. Zoeller Law can assist both you and your tax professional in structuring your settlement to avoid or minimize taxes as much as possible.
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Florida does not have an individual state income tax for its citizens. Therefore, typically, Florida citizens do not pay Florida state income tax on money they receive from a personal injury claim.
Although there are no Federal Tax Laws that specifically address the taxation of a personal injury settlement, under the general rule, compensation for physical sickness or physical injuries is exempt from federal taxation. Under this exemption, damages may be included that relate to medical bills, pain and suffering, mental anguish resulting from a physical injury, and loss of earnings which are directly the result of the physical injury. A portion of a settlement or judgment is likely to be taxable (for example, punitive damages; post-judgment or settlement interest; and damages due to noneconomic elements); many times, some components of a settlement or judgment are exempt from federal taxation as well.
Wrongful death cases need to be reviewed carefully. In Florida, wrongful death statutes allow for numerous types of damages and are not solely punitive. Since all settlements may contain some taxable and nontaxable items, you should consult a knowledgeable tax consultant to determine how your settlement was distributed and what reporting requirements exist.
The tax implications can vary depending on the state where the plaintiff lives, since each state has different tax laws. As such, one cannot assume another state will follow the same process as Florida regarding the taxation of a wrongful death settlement.
Preparing Your Settlement For Reporting On Tax Returns
At tax time, here is a helpful checklist to navigate:
Properly categorize payments. When part of your settlement involves compensation representing wages (this is common in employment litigation), those portions will appear on your W-2 form. All other taxable portions will appear on Form 1099-Misc. How something is reported impacts how it is taxed.
Retain documentation. Keep all documents relevant to your settlement, including any settlement agreements; any court orders relating to your case; communication with the defendant or insurance company; and documentation of your attorney’s fee arrangement. Documentation helps defend against any inquiry made by the IRS regarding how your settlement was handled/treated.
Correctly report taxable portions appropriately. Interest earned on any judgment/settlement as well as other taxable portions of a settlement should be reported as “other income” on Form 1040. Since the defendant or insurance carrier issuing Form 1099 has already notified the IRS of the payment made, ignoring receipt of Form 1099 would not aid you in reducing liability.
Seek professional assistance as needed. The rules surrounding settlements for tax purposes are quite complex. For larger settlements, hiring a certified public accountant (“CPA”) or attorney specializing in taxation may prove cost-effective.
Zoeller Law is ready to assist you with any concerns/questions you may have about protecting your interests when negotiating or settling a claim. Zoeller Law serves clients throughout Florida and in West Palm Beach.
This information is general and is not tax advice. Speak with a qualified tax professional about your specific settlement, judgment, or recovery.
