In some cases, the IRS can take a part of personal injury settlements if you have back taxes.
Perhaps the IRS has a lien on your property already, and if so, you could find yourself losing part of your settlement in lieu of unpaid taxes. This can happen when you deposit settlement funds into your personal bank account.
Alternatively, the IRS may not have filed a lien, but could still claim taxes against a portion of your compensation. The IRS can only pursue those portions of the settlement not intended as reimbursement for property loss or physical injury.
So, while this may not always happen, it is possible that the IRS might take at least some of your personal injury settlement.
Filing Tax Liens: Why Does the IRS Do This?
The IRS has a great deal of power and reach when it comes to filing tax liens against anyone who has not paid their federal taxes, assuming demands for payment have been made but not met.
With a tax lien, this doesn’t automatically transfer the ownership of property to the IRS, but it will establish a claim, potentially impacting how that property can be used. As an example, when liens extend to your bank account, you could find yourself temporarily prevented from withdrawing or deploying funds. This disruption to service will remain until the lien is resolved.
If you have a personal injury settlement case and you are working with a personal injury attorney, it is vital to be transparent about any potential tax liens or complications. If your lawyer is aware of pressing issues, they can advise you about how your settlement might be impacted, and they can also discuss ways of lessening any possible tax burden.
Court Judgments and Personal Injury Settlements: How Does the IRS Treat These Differently
As a taxpayer, you might receive compensation from either a court judgment or an out-of-court settlement if you are involved in a personal injury claim. When you are determining whether the IRS might take some or all of that settlement, it’s critical to make this distinction.
If a judge or jury has awarded you damages through a court verdict, the IRS is not permitted to challenge the nature of any compensation due.
When personal injury settlements are handled out of court, though, there is more latitude to configure settlement payments in a more beneficial way for tax purposes. In this case, IRS auditors can examine settlements for accuracy. The auditing recommendations used are designed to establish whether personal injury compensation complies with all federal tax laws.
Auditors will typically examine the following:
- If the settlement has been accurately reported
- If part of the compensation can be considered interest, thus considered ordinary income
- Whether payments have been received net or gross, including all legal and associated fees
- If payments were properly distributed among taxable and non-taxable amounts
- Whether portions of the settlement not considered income were received due to injury or physical illness
- If expenses incurred for the treatment of emotional distress were previously deducted as medical expenses, they will be taxed
- Punitive damages are taxed, whether or not awarded for injury or illness
A Federal Tax Lien Could Affect the Calculation of Your Personal Injury Settlement
If you fail to file your income tax return, the IRS will place a tax lien on you by estimating how much you earned, then calculating taxes accordingly.
Personal injury settlements for taxpayers almost always include compensation for lost earnings due to time off after an injury or accident.
When you have no documentation to substantiate these lost earnings, your attorney will use your tax returns as proof of earnings. In this event, federal tax liens may not affect the calculation of your settlement. In the absence of tax returns, though, a tax lien might complicate negotiations for compensation of lost earnings.
Will the IRS Garnish a Personal Injury Settlement?
While an experienced personal injury lawyer can help you navigate any tax issues associated with a personal injury claim, you should also consider consulting an accountant or tax professional for more robust and specialized advice.
You should also bear in mind that even if the IRS is not in a position to take a personal injury settlement for any other reason than unpaid taxes, other state and federal authorities may still do so.