Are Malpractice Settlements Taxable?

Receiving a settlement from a malpractice case introduces financial questions, with taxation being a primary concern. A malpractice settlement is compensation for harm caused by a professional’s negligence. The tax implications hinge on the specific nature of the damages the payment is intended to cover, as federal law treats different types of compensation differently.

Determining the Taxable Portions of a Settlement

The taxability of a malpractice settlement is determined by the “origin of the claim” doctrine. This principle means the tax treatment of the settlement funds depends on what the payment is intended to replace. If the settlement replaces something that would have been non-taxable, like compensation for a physical injury, that portion of the settlement is also non-taxable. Conversely, if it replaces something that would have been taxed, such as lost wages, that portion is taxable.

Compensatory Damages for Physical Injuries or Sickness

A portion of malpractice settlements is designated as compensatory damages for physical injuries or sickness. Under Internal Revenue Code Section 104, amounts received for personal physical injuries or physical sickness are excluded from gross income. This means that if a settlement compensates for observable bodily harm, that amount is not taxable. For this exclusion to apply, there must be a direct causal link between the payment and the physical injury sustained.

Damages for Emotional Distress

The tax treatment of damages for emotional distress is more nuanced. Compensation for emotional distress is taxable, with an exception when the distress is a direct result of a physical injury or sickness. In such cases, the payment for emotional distress is considered part of the non-taxable compensation for the physical injury. If the emotional distress does not stem from a physical injury, any settlement amount allocated to it is taxable income.

Lost Wages or Profits

Settlement payments intended to replace lost wages or business profits are taxable as ordinary income. The reasoning is that these payments substitute for income that would have been earned and taxed had the malpractice not occurred. Whether the payment is for past or future lost earnings, it is subject to the same income tax rules as the wages it replaces.

Punitive Damages

Punitive damages are awarded to punish a wrongdoer for egregious conduct rather than to compensate the victim for a specific loss. The Internal Revenue Service (IRS) considers all punitive damages to be taxable income. This rule applies even if the punitive damages are connected to a case involving physical injury, and they must be reported as “Other Income” on a tax return.

Interest

Settlement agreements often include interest on the principal amount, especially if payments are delayed or made over time. Any interest paid as part of a settlement is considered taxable interest income. This interest is separate from the damages themselves and must be reported on the recipient’s tax return.

The Role of the Settlement Agreement

The settlement agreement is a document that outlines the resolution and serves as the primary evidence for how the funds should be treated for tax purposes. For the agreement to be effective, it must explicitly allocate the total settlement amount among the various categories of damages. The agreement should specify the exact dollar amounts designated for non-taxable damages, such as those for physical injuries, and for taxable damages, like lost wages or punitive damages.

The absence of a clear allocation in the settlement agreement can create significant tax risks. If the agreement is silent or vague about the purpose of the payments, the IRS may have greater latitude to interpret the entire settlement as taxable income. While the IRS is not necessarily bound by the agreement’s allocation, a reasonable and explicit allocation provides strong evidence of the parties’ intent and is a proactive step to justify the exclusion of certain funds from gross income.

Reporting Settlement Income on Your Tax Return

Tax Forms from the Payer

The payer of the settlement, typically the defendant or their insurance company, may be required to issue an informational tax form to the recipient and the IRS. This is often a Form 1099-MISC, Miscellaneous Information, or a Form 1099-NEC, Nonemployee Compensation. It is important to note that the amount reported on this form may be the gross settlement amount, including any non-taxable portions and payments made directly to attorneys. The recipient is still responsible for determining the correct taxable amount to report on their own return.

Reporting on Form 1040

The taxable portion of the settlement should be reported on the recipient’s Form 1040. This is typically done on Schedule 1 (Form 1040), Additional Income and Adjustments to Income, under the “Other income” line. The taxpayer should report only the amount determined to be taxable, even if a Form 1099 reports a larger figure. It is advisable to attach a statement to the tax return explaining the discrepancy and detailing the calculation of the taxable portion based on the settlement agreement’s allocations.

Handling Attorney’s Fees

The treatment of attorney’s fees can be complex. For tax purposes, the recipient is generally considered to have received the gross settlement amount, including any portion paid to their attorney under a contingency fee arrangement. The ability to deduct these legal fees depends on the nature of the claim. For claims involving unlawful discrimination, attorney’s fees can often be deducted “above the line” as an adjustment to income on Schedule 1 (Form 1040). For most other claims, including many malpractice cases, these fees are classified as a miscellaneous itemized deduction, which is currently suspended for individuals under the Tax Cuts and Jobs Act. This suspension effectively makes the attorney’s fees non-deductible for many taxpayers, resulting in tax being owed on income that was never personally received.