Are Annuity Payments on Lawsuit Settlements Tax Free?

Large payouts from lawsuits, which can range into the millions, are rarely paid as one lump sum. Instead, settlements often pay through annuities, providing regular payments over a number of years. Depending on the type of recovery, plaintiffs might pay taxes on some, all or none of the annuity payments they receive. Tax law classifies the type of recovery based on the facts of the case, sometimes disregarding the terms of the settlement.

When filing suit, the person who was injured can seek compensatory damages and punitive damages. Punitive damages, which courts can award to make an example of the defendant, are almost always taxable. Compensatory damages, which compensate the wronged party for an injury they suffered, can be tax-exempt, depending on what type of injury the compensation is for. Tax law specifically exempts recoveries for personal physical injury as well as emotional distress on account of personal physical injury. Non-physical personal injuries, such as improper termination seeking lost wages, are taxable. After all, the lost wages would have been subject to taxes had the plaintiff not been terminated.

Structured settlements are often tax-efficient for both the plaintiff and defendant. While the defendant has a longer time to make the payments, the plaintiff can stretch the recovery over several tax periods. This is especially helpful for recoveries with large taxable awards, which would skyrocket the plaintiff into the top tax-bracket the year of the settlement. Annuity payments could keep the plaintiff in a lower tax bracket, reducing the total amount of tax due on the settlement. Further, if a settlement consists of both taxable and nontaxable recoveries, each annuity payment would be taxable proportionately. For example, a recovery of $1 million consisted of $800,000 in nontaxable physical injury damages and $200,000 taxable punitive damages. Each annuity payment would be 80 percent tax-exempt income.

Tax law requires IRS auditors to look at the facts and circumstances of each settlement to determine how much is properly classified as nontaxable. In a 1997 Tax Court case, LeFleur v. Commissioner, the IRS reclassified a settlement as taxable despite the express language in the settlement, and the courts upheld the IRS examination. Auditors will look to the claims made in the lawsuit to see whether the causes are for personal physical injury, personal emotional injury, nonphysical injury or punitive damages. If the claims in a lawsuit stem from nonphysical damages, simply having the lawyers specify that 80 percent of the settlement is payment of personal physical injury does not make the award tax-free.

Interest received from an annuity payout counts as taxable income. In some cases, tax law requires recipients to impute interest if the settlement does not expressly set an interest rate. The IRS publishes tables to help calculate the exact amount of interest received with each payment when interest must be imputed. Interest income is taxable even if it is earned on a payout that is otherwise tax-free.