Can the IRS Garnish My Personal Injury Settlement?

Tax Liens, Levies, and Personal Injury Settlements

In many cases, the IRS can seize a portion of personal injury settlements if you owe back taxes.

If the IRS has a federal tax lien on your property, they have a legal claim to your settlement. The actual collection usually happens via a levy, where the IRS legally seizes the funds. This can happen before the check reaches you—by intercepting it from the insurance company or your attorney—or after you deposit the funds into your bank account.

A common misconception is that “non-taxable” settlements are safe. While the IRS does not tax compensation for physical injury, they can still levy those funds to pay off a pre-existing tax debt from previous years. The IRS generally has the power to pursue any part of a settlement to satisfy a debt, regardless of whether that specific compensation is considered taxable income.

Filing Tax Liens vs. Levies: What You Need to Know

The IRS has significant power to file tax liens against taxpayers who have ignored demands for payment. It is important to understand the difference between the two:

• A Tax Lien: This is a legal claim against your property (including future settlement rights) to ensure the IRS gets paid. It protects the government’s interest.
• A Tax Levy: This is the actual seizure of property. When a levy is placed on your bank account or settlement funds, you are prevented from withdrawing or using those funds until the debt is satisfied or the levy is released.

If you are working with a personal injury attorney, transparency is vital. If your lawyer knows about a lien early on, they may be able to negotiate with the IRS to “subordinate” the lien or arrange for a partial release so that legal fees and medical bills can be paid first.

How the IRS Evaluates Settlements vs. Court Judgments

The IRS treats court-ordered judgments and out-of-court settlements differently. If a judge or jury awards specific damages through a verdict, the IRS typically accepts that allocation (e.g., distinguishing between physical injury and punitive damages).

With out-of-court settlements, however, the IRS has more latitude to challenge how the money is “labeled.” IRS auditors may examine a settlement to ensure it isn’t being used to hide taxable income under the guise of “non-taxable” physical injury compensation. They typically look for:

• Whether the settlement allocation matches the “intent” of the person paying it.
• Whether part of the compensation is actually interest, which is treated as ordinary income.
• Whether punitive damages were included, as these are almost always taxable.
• Whether you previously took a tax deduction for medical expenses related to the injury (which makes that portion of the settlement taxable).

The Role of Tax Returns in Settlement Calculations

Personal injury claims often include “lost earnings.” To prove these losses, your attorney usually needs to provide your tax returns as evidence of what you were earning before the accident.

If you have not filed tax returns, the IRS may have filed a Substitute for Return (SFR) for you, which often overestimates your debt and leads to a higher lien than necessary. Furthermore, failing to file returns can make it much harder for your attorney to prove your lost wage claim to an insurance company, potentially lowering your total settlement amount.

Can Other Authorities Garnish a Settlement?

Even if you do not owe the IRS, other entities can place a lien on your settlement. State tax authorities, child support agencies, and healthcare providers (via medical liens) often have the right to be paid directly from your settlement proceeds before you receive your final check.