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Receiving a settlement check after a lawsuit can be a huge relief. Whether it’s financial compensation for a personal injury, workers’ compensation, or wrongful death claim, settlement money helps victims cover essential living and legal expenses. In addition, claimants can recover financially from the injuries, damages, and losses caused by someone else’s negligence.
However, many people often wonder whether the IRS has the power to take their settlement money, especially if they owe back taxes. Under the law, the IRS has the authority to seize certain funds to cover unpaid taxes. However, not all settlement money is automatically at risk. Let’s explore IRS collection rules, which settlements may be affected, and how to protect your money to avoid surprises when your settlement check arrives.
When Can the IRS Take Settlement Money?
The IRS can seize settlement money if you have outstanding tax debt. This typically happens through two collection methods: tax liens and levies.
You Owe Back Taxes
If you owe back taxes, the IRS may place a levy on your bank account. This allows them to collect money from your deposits, including settlement funds. If no payment plan has been arranged, the IRS may take a portion or all of the funds to cover unpaid taxes.
Tax Liens on Settlement Money
Another way the IRS can claim settlement money is through a tax lien. A tax lien is slightly different from a levy. Instead of immediately taking the funds, a lien is a legal claim on your assets, including your settlement payment. This means your settlement may be redirected toward your tax debt before you receive anything.
Types of Settlements That May Be at Risk
As mentioned earlier, not all settlements are treated the same under IRS rules. Some settlement funds are protected from taxation and collection, while others are considered taxable income and may be seized if you owe past-due taxes.
Personal Injury Settlements
Personal injury settlements are often protected from IRS collection. This is because they are meant to compensate victims for physical injuries, damages, or losses. If your settlement is awarded due to a bodily injury, the IRS generally does not consider it taxable income. Hence, it cannot be taken for unpaid taxes.
Workers’ Compensation Claims
In addition, settlements awarded for workplace injuries are exempt from IRS collection. If you received compensation because of an injury sustained at work, the IRS cannot tax these payments or take them for back taxes.
Wrongful Death and Medical Malpractice Settlements
However, wrongful death and medical malpractice settlements may be partially taxable, depending on how they are structured. If a portion of the compensation is classified as lost wages or punitive damages, the IRS may tax it and claim a portion to cover outstanding tax debt.
Insurance Payouts and General Settlements
Funds received from insurance claims or general legal settlements may be fully taxable, especially if they include compensation for lost wages or emotional distress (without physical injury). The IRS considers these taxable income. Hence, they are subject to collection if tax liens or levies exist on the claimant’s assets.
How Do IRS Liens and Levies Affect Settlement Money?
If you owe unpaid taxes, the IRS can use liens or levies to claim part or all of your settlement money.
The Difference between a Tax Lien and a Levy
A tax lien is a legal claim on your assets. This means your settlement funds may be redirected to pay off tax debt before you receive them. A tax levy, however, allows the IRS to take money directly from your bank account, including funds from your settlement check.
What Happens If Your Settlement Is Deposited Into a Bank Account With a Levy?
If your settlement check is deposited into an account that has an active IRS levy, the bank may freeze the funds and send them to the IRS automatically. This means you may lose access to your settlement money, depending on the amount owed.
Tax liens and levies do not apply to protected settlements, such as workers’ compensation or personal injury awards. Conversely, they apply to settlements for lost wages, emotional distress (without physical injury), and punitive damages.
How to Protect Your Settlement Money from IRS Collection
If you are expecting a settlement check and you owe taxes, there are ways to protect your money.
Negotiate a Payment Plan Before Receiving Settlement Money
One of the best approaches is to negotiate a payment plan with the IRS before receiving your settlement. Setting up an IRS Installment Agreement allows you to make payments over time. This reduces the likelihood of an immediate lien or levy on your settlement funds.
Request Temporary Hardship Status from the IRS
If you are facing financial difficulty, you may qualify for Currently Not Collectible (CNC) status. This temporarily prevents the IRS from enforcing collection on tax debt. It can also protect your settlement money if you need it to cover essential expenses.
Document That Your Settlement Is Non-Taxable
If your settlement falls under an exempt category, such as workers’ compensation or bodily injury compensation, it’s helpful to document the purpose of the funds. Keeping clear records which proves that the settlement is non-taxable ensures you can defend your funds against wrongful collection attempts.
Get Professional Tax Advice
Also, if you have concerns about IRS collection, you can consult a tax professional or financial advisor. Working with a tax expert can help you secure your money and avoid unnecessary taxation.
Are Settlement Funds Taxable?
Many people wonder whether they need to pay taxes on settlement money, even if it is not subject to IRS collection. The answer depends on the type of financial compensation or settlement funds received.
Taxable vs. Non-Taxable Settlements
Essentially, settlements for physical injuries or workers’ compensation claims are generally not taxed. This means recipients do not need to report them as income. However, punitive damages, lost wages, and emotional distress payments (without physical injury) are taxable under IRS rules.
Reporting Settlement Money on Your Taxes
If your settlement award includes both taxable and non-taxable portions, it’s important to separate these amounts when filing taxes. A tax professional can help properly report settlement funds and ensure that you only pay taxes on the required portion.
Protecting Your Settlement Money from IRS Collection
The IRS has the authority to take settlement money in certain cases, but not all funds are automatically at risk. Personal injury settlements and workers’ compensation claims are generally protected, while lost wages, punitive damages, and insurance payouts may be subject to IRS rules.
If you owe back taxes, the IRS may use liens or levies to claim a portion of your settlement. However, negotiating payment plans, documenting exemptions, and seeking professional guidance can help you protect your money.
Before depositing any settlement funds, it’s important to understand IRS policies, check for outstanding tax debt, and consider working with a tax professional to ensure your settlement remains secure.
Call High Rise Financial to Apply for a Pre-Settlement Funding Today!
Do you need money while your lawsuit is ongoing or awaiting your settlement check? A lawsuit loan can provide you with the immediate cash advance you need to cover medical bills, rent, and expenses while your case is pending. Contact us today at High Rise Financial or call (866) 407-6404 to apply for pre-settlement funding.