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Are Lawsuit Settlements Taxable in California?

If you're involved in a lawsuit in California, you may be wondering whether any settlement or award you receive is taxable. The good news is that, in most cases, personal injury settlements are not taxable in California

However, it's still important to understand the state's rules and regulations, so you can make informed decisions and avoid any unexpected tax liabilities.

Generally, settlement funds and damages received from a lawsuit are taxable income according to the IRS. Nonetheless, personal injury settlements - specifically those resulting from car accidents or slip and fall incidents - are typically exempt from taxes. But there are exceptions to every case, and each lawsuit is unique.

Below you’ll find a breakdown of what awards are subject to taxes, which aren’t, and how the IRS comes into play in regards to your case’s settlement. 

Types of Awards and Settlements

Determining how much of a wrongful death settlement or a personal injury settlement will go to the injured party and how much will be subject to taxes by the IRS and State of California requires a close examination of the specific types of damages outlined in the settlement agreement. Here is a quick breakdown of the various types of damages in a California personal injury lawsuit and their tax implications.

Physical Injury Damages

If you receive a settlement for physical injuries sustained as a result of someone else's negligence, the settlement is typically not considered taxable income in California. This includes settlements for medical expenses, lost wages, and other related damages.

Emotional Distress Damages

Emotional distress settlements are also generally not taxable in California, as long as they are related to physical injuries sustained in the same incident. This means that if you receive a settlement for both physical and emotional distress, the entire settlement may still be considered non-taxable.

Punitive Damages

Punitive damages are intended to punish the defendant for their wrongful behavior, and are often awarded in cases of intentional misconduct or gross negligence. In California, punitive damages are considered taxable income. However, these awards are relatively rare, and typically only a small portion of any settlement. 

What Lawsuit Settlement is Taxable?

While personal injury settlements are generally not taxable in California, there are some other types of settlements that may be considered taxable income. 

This includes settlements for:

  • Lost wages
  • Property damage
  • Defamation
  • Breach of contract
  • Unlawful discrimination
  • Punitive Damages

It's important to review your specific settlement agreement to determine whether any portion of it is taxable. In some cases, you may be able to negotiate the terms of your settlement to minimize your tax liability.

What Lawsuit Settlement is not Taxable?

Compensation money awarded for visible injuries is considered tax-free, so there is no need to include these settlements in your yearly tax report.

As mentioned, settlement awards from personal injury lawsuits that demonstrate "observable bodily harm" are not taxable by the IRS. Such as car accidents, slip and falls, and certain public transportation accidents to name a few. 

If emotional distress is a result of physical injury or sickness caused by an accident, any settlement money received for it is nontaxable. Therefore the emotional distress must be of direct correlation to the physical harm caused. 

Also, some medical expense settlements are not taxable. If you did not take an itemized deduction for medical visits related to emotional distress or physical injury in prior years, they are considered nontaxable. However, if you settled and were reimbursed for medical expenses after previously taking a deduction, you may be required to pay taxes on the settlement in that year.

Attorney Contingency Fees

It's natural for plaintiffs to want to receive their full compensation for personal injury, minus any contingency fees paid to their attorneys, once a case has been settled. It is important to note that under The 2017 Tax Cut and Jobs Act (2017 tax act) specifically for taxed settlements, your payout can be much lower. 

This is due to lawmakers voting in the 2017 Tax Act which considers a client’s attorney fees, like a contingency fee, as not deductible. Before 2017, clients were able to deduct their contingency fees from the overall payout of the settlement. That isn't the case anymore, so you can expect less from the overall sum of your settlements once state, federal, and attorney fees come into play.

The IRS Has The Final Say

At the end of the day, the IRS has the final say! If you receive a settlement in California that is considered taxable income, you will need to report it on your tax return. 

You will typically receive a Form 1099-MISC, which reports the amount of taxable income you received during the year. If you do not receive this form, you should still report the settlement on your tax return, as you are still responsible for paying taxes on any taxable income you receive. 

To ensure you are following tax codes and laws correctly, we suggest speaking with a certified public accountant if you are having trouble differentiating which part of your settlement is taxable and which isn't. There are times when both taxable and non taxable damages can be awarded for the same case. 

West Coast Trial Lawyers Can Help Mitigate Your Settlement Taxes

At West Coast Trial Lawyers we have professional counsel that can point you in the right direction and help you mitigate your tax risk. Once you've reached your settlement our firm can give you insights into how to properly file your 1099-Misc and fully understand what settlements are taxable and which are non-taxable.

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