Can the IRS Take Your Settlement Money?
Understand the tax treatment of settlement payments and the IRS's capabilities in collecting associated tax liabilities.
When individuals receive a settlement, a common concern is how it might affect their taxes and whether the Internal Revenue Service (IRS) can claim a portion of the funds. While some settlement money is not subject to taxation, a significant amount is, and the IRS has established mechanisms to ensure tax compliance. Understanding these rules helps clarify what might be owed and how the IRS becomes aware of these payments. The tax implications of a settlement depend on the specific nature of the damages or compensation received.
Taxability of Settlement Payments
The tax treatment of settlement payments is not uniform; it depends on the origin of the claim and the type of damages awarded. Generally, the IRS considers all income taxable unless a specific exclusion applies. Internal Revenue Code Section 104 provides exclusions for certain types of payments.
Settlements for personal physical injuries or physical sickness are generally not taxable. This exclusion applies to compensation received for medical expenses, pain and suffering, and other losses directly related to the physical harm. The physical injury or sickness must be observable or verifiable for the exclusion to apply.
Emotional distress settlements have a nuanced tax treatment. If emotional distress arises directly from a physical injury or sickness, the compensation is typically not taxable. However, if emotional distress is the only injury claimed and not linked to a physical injury, the settlement amount is generally taxable.
Lost wages or lost profits included in a settlement are typically taxable. Since these amounts replace income that would have been taxed normally, they are treated as ordinary income. These payments may be subject to federal income tax, state income tax, and employment taxes like Social Security and Medicare.
Punitive damages are always taxable, regardless of the nature of the underlying claim. Even if received in a case involving physical injuries, punitive damages must be included in taxable income. Similarly, any interest earned on a settlement award, whether pre-judgment or post-judgment, is always taxable.
Attorney fees can also impact the taxable amount of a settlement. If a portion of a settlement is paid directly to an attorney as a contingent fee, the client is generally considered to have received the full settlement amount for tax purposes, even if they never physically touch the portion paid to the attorney. However, for settlements related to physical injuries, where the settlement itself is non-taxable, the attorney fees related to that non-taxable portion are also effectively non-taxable to the client. For taxable portions of a settlement, such as punitive damages or lost wages, the attorney fees may not be deductible by the individual.
Reporting Settlement Income
The IRS becomes aware of potentially taxable settlement payments through various reporting mechanisms. Payers of settlements, such as insurance companies or defendants, are often required to issue specific tax forms to both the recipient and the IRS. This allows the IRS to cross-reference reported income with tax returns.
Form 1099-MISC or Form 1099-NEC are commonly used to report settlement payments. Form 1099-MISC reports various miscellaneous income, while Form 1099-NEC is for nonemployee compensation. The payer is generally required to issue a Form 1099 if the payment is $600 or more in a calendar year.
It is common for the payer to issue Forms 1099 for the full settlement amount to both the plaintiff and the plaintiff’s attorney, even if attorney fees are deducted before the client receives their share. This occurs because the IRS requires reporting of gross proceeds, and the payer may not know the exact division. Even if a Form 1099 is not received, individuals are still responsible for reporting all taxable income on their tax return.
Accurate record-keeping is important. Maintaining detailed documentation, including the settlement agreement, legal complaints, and related correspondence, helps substantiate the tax treatment of funds. This documentation can be crucial if the IRS later questions reported amounts or tax exclusions.
IRS Collection Powers
If taxes are owed on a settlement and remain unpaid, the IRS possesses significant authority to collect delinquent amounts. The collection process typically begins with notices and bills sent to the taxpayer, outlining the amount due and requesting payment. Ignoring these communications can lead to escalating enforcement actions.
The IRS can impose various collection actions to recover unpaid taxes. These include filing a Notice of Federal Tax Lien, a legal claim against a taxpayer’s property, including real estate and financial assets. A tax lien can negatively affect credit and make it difficult to sell or refinance property. The IRS can also issue a levy, the legal seizure of property to satisfy a tax debt. This includes levying bank accounts or garnishing wages, requiring an employer to send a portion of an individual’s paycheck directly to the IRS.
For taxpayers who cannot pay their tax liability immediately, the IRS offers resolution options. An Installment Agreement allows taxpayers to make monthly payments to pay off their tax debt, including penalties and interest. Another option is an Offer in Compromise (OIC), which allows certain taxpayers to settle their tax debt for a lower amount than what is owed. An OIC is generally approved if the IRS determines the taxpayer cannot pay the full amount due to financial hardship. These options provide pathways for taxpayers to address their tax obligations and avoid severe collection measures.