I write the following under this explicit disclaimer: I am not a tax lawyer nor am I particularly qualified to give tax advice. The following is a simplified version of how settlements are treated under tax law. For further guidance, I would suggest seeking the advice of a qualified tax professional.
Generally, settlement proceeds from personal injury claims are not subject to either state or federal taxes. This is true whether your case was settled out of court, out of court after lawsuit filed, or resolved after a jury trial. This means that a plaintiff’s compensation for medical expenses, lost income, pain and suffering, loss of consortium, and legal fees in a personal injury case are all treated as non-taxable income under the tax laws.
There are, however, executions to this rule. A major exception to this rule is if you receive punitive damages. These damages are meant to punish the wrongdoer from performing similar behavior in the future. Most personal injury cases do not involve punitive damages. Some cases involving gross negligence will qualify (i.e. drunk driving or intentional criminal act) but they are only rarely awarded. For damages to be considered punitive, they almost always must be awarded after a jury trial. If this occurs, your attorney will need make sure the judgment clearly states what damages are considered compensatory and what damages are considered punitive. This should help you or whoever prepares your taxes to have the proper documentation to show the IRS.
Some other exceptions are if the lawsuit arises out of a breach of contract or if the settlement is only for emotional distress or employment discrimination. The final major exception is income from interest on a judgment.
Again, The Gerring Law Firm does not specialize in tax law. I advise all clients to make sure they double check with their accountants prior to filing. The tax laws are complex and always changing. It is best to talk with a specialist to make sure your situation is covered.