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Valor Tax Relief Team
Professional Tax Resolution Specialists
Key Takeaways
- The IRS can reach settlement proceeds when back taxes are owed, but exposure depends on how the payout is categorized for tax purposes.
- Compensatory injury and workers' comp payments are usually insulated, while employment-related awards, punitive damages, and non-physical distress amounts face the greatest collection risk.
- Taxable pieces—like back pay, interest, and some attorney fee allocations—are the first targets, especially if they land in an account already under levy.
- Bank and wage levies, plus direct levies on attorneys or insurers, let the IRS divert settlement dollars before you ever touch them.
- Protection steps: lock in a payment plan or OIC, seek CNC status, keep exempt funds separate, and spell out each component in the settlement agreement.
- Move early with a tax pro and your attorney so taxable vs. non-taxable portions are documented and shielded before the IRS issues a levy.
Introduction
Dealing with the IRS is stressful enough, but when you're expecting a lawsuit settlement, the stakes feel even higher. One of the most common questions taxpayers ask is: Can the IRS seize a settlement?
The short answer: Yes, the IRS can seize or levy certain types of settlement payments if you owe federal tax debt.
The reality is much more complex than a simple yes or no. Different settlement types receive different tax treatment, and various safeguards exist—including state-level exemptions, federal restrictions, and particular tax regulations—that can impact whether your funds are at risk. Learning how these regulations work enables you to identify which parts of your settlement might be vulnerable and determine what approaches you can take to safeguard your money.
This in-depth guide breaks down how the IRS views settlements, when it can take them, and what you can do if you're facing tax debt while waiting for settlement funds.
How the IRS Classifies Settlements for Tax and Levy Purposes
Settlement payments receive different treatment depending on their nature. The IRS examines what the settlement covers, its tax status, whether you have outstanding federal tax obligations, where the settlement money is being placed, and how easily the funds can be accessed.
Taxable vs. Non-Taxable Settlement Components
Settlement agreements typically contain various elements that receive different tax treatment. Certain portions qualify for income tax exemptions, while other parts are subject to full taxation and can be seized by the IRS. Elements that are usually taxable consist of back pay, interest payments, punitive damage awards, emotional distress compensation unrelated to physical harm, and specific attorney fee allocations. Exempt elements commonly consist of payments for physical harm or illness, medical expense reimbursements that weren't previously claimed as deductions, and certain wrongful death compensation. Exempt elements are usually safe from seizure, while taxable elements remain at risk.
Why the Classification Matters for IRS Seizures
The IRS generally presumes that combined settlements are taxable income unless you can demonstrate otherwise with proper paperwork. This underscores why comprehensive settlement documentation is critical. Without proper categorization, even portions that should be exempt could be considered collectible, particularly when they're mixed together in the same bank account.
When the IRS Can Legally Seize a Settlement
Once a settlement is finalized, the IRS typically has the authority to take any part deemed taxable, any money placed into a bank account that's under levy, and any settlement funds sent directly to you during an active levy or wage garnishment. That said, the IRS is prohibited from seizing funds when such action would conflict with particular federal protections or judicial directives.
Personal Injury Settlements
Most personal injury settlements are not taxable, which significantly reduces the IRS's ability to levy these funds. However, not all parts of a personal injury settlement are automatically exempt.
Portions That Are Usually Protected
The IRS typically cannot take payments for physical harm, pain and suffering connected to the injury, or medical expense reimbursements that weren't previously claimed as deductions. These represent compensatory, tax-exempt damages that are normally protected from IRS collection actions.
Portions That Are Vulnerable to IRS Levy
Even within personal injury settlements, the IRS can take punitive damage awards, legal fees for certain types of claims, settlement interest payments, compensation for emotional distress not tied to physical harm, and certain lost wage components. The tax treatment of lost wages in injury settlements hinges on the underlying reason for the income loss.
If the lost wages come from a physical injury, they're usually not taxed and the IRS generally can't take them. They have to be clearly connected to the physical injury to qualify. If the lost wages come from a non-physical issue, like workplace discrimination, harassment, or defamation, they are taxed, and the IRS can seize them if you owe back taxes.
Example Scenario
For example, if you were awarded $150,000 for physical injuries and $30,000 for lost wages because those injuries kept you from working, the $180,000 is generally not taxable. However, if the $30,000 portion is paid separately and the settlement doesn't clearly tie it to the physical injury, the IRS may consider that portion taxable. That said, the wording in the settlement agreement is extremely important. It should clearly state that the lost wages are "because of" the physical injuries to protect that portion from taxes and potential IRS levy.
Workers' Compensation Settlements
Workers' compensation settlements are generally considered non-taxable, which often shields them from IRS levy. These payments are made for work-related injuries or illness and are usually protected under federal law.
Why Workers' Comp Payments Are Generally Safe
Because workers' compensation benefits are not considered taxable income, the IRS typically cannot seize these funds. However, if the settlement includes non-injury related portions such as wage replacement categorized incorrectly, or if the funds are deposited into an account already under levy, they may still be vulnerable. Keeping workers' compensation funds in a separate account can provide additional protection.
Wrongful Death Settlements
Wrongful death settlements often include multiple components, some of which may be taxable and some of which are not.
Portions That Are Usually Exempt
The majority of compensatory awards, including payments for loss of life, burial costs, loss of companionship, and intangible losses connected to the death, are usually exempt from taxation and consequently protected from IRS collection. Wrongful death cases represent a unique situation where punitive damages can be tax-free. According to IRC Section 104(c), punitive damages escape taxation only when:
- The state's wrongful death law only allows punitive damages and does not allow compensatory damages, AND
- The payouts were received after 1996
This regulation applies in only a handful of jurisdictions. Alabama, for instance, permits only punitive damages in wrongful death matters, making those awards potentially tax-exempt. Throughout the rest of the country, punitive damages in wrongful death cases remain taxable and subject to IRS collection.
Portions That May Be Seized
The IRS might still collect interest payments on the settlement, or take attorney fee portions, based on state laws and the nature of the claim. Maintaining accurate records for every element in the settlement is vital to avoid incorrect collection actions.
Employment-Related Settlements
Employment-related settlements face the highest risk of IRS collection. Compensation for wrongful termination, unpaid salary, back pay, front pay, lost benefits, and discrimination or harassment claims are usually classified as taxable income. Since these are treated as income, the IRS has the power to collect them even before the money reaches you.
Taxable Employment Settlements
Almost all components of an employment-related settlement are taxable. Lost wages are reported on a W-2, and emotional distress awards not tied to a physical injury are reported on a 1099-MISC. These awards fall directly within the IRS's levy authority, leaving little room for protection.
Limited Non-Taxable Portions
Occasionally, emotional distress compensation connected to a physical injury might be tax-exempt, but the majority of employment settlements contain substantial taxable elements. Proper paperwork is essential for distinguishing between these different amounts.
How the IRS Seizes Settlement Funds
Learning how IRS collection procedures work helps you prepare for and address any actions taken against your settlement funds.
IRS Bank Levies on Settlement Deposits
When your bank account is subject to a levy, the IRS can take whatever money is available in that account, including recently deposited settlement payments. After funds enter the account, they lose their protection unless you can demonstrate they qualify for exemption.
IRS Wage Levies on Structured Settlements
Some settlements are structured into recurring payments. These payments may be treated similarly to wages and can be levied incrementally. This occurs most often in employment settlements, long-term personal injury awards, or structured workers' compensation settlements.
Direct Levies to Attorneys or Insurers
The IRS has the authority to send a levy notice directly to your settlement attorney, the insurance company, or the settlement processing company. After receiving notification, these entities must legally forward the collected money straight to the IRS. Your attorney cannot turn these funds over to you without facing potential legal consequences.
State-Specific Protections Against IRS Seizure
Although the IRS operates under federal law, state laws can affect exemptions. Certain states explicitly protect personal injury settlements, workers' compensation funds, or wrongful death awards. Other states offer minimal protections. Since state laws vary widely, consulting a professional in complex cases is often necessary to maximize protections.
Strategies to Protect Your Settlement From IRS Seizure
When you have unpaid taxes and expect to receive a settlement, implementing proactive measures can help you retain a substantial amount of your settlement payment.
Resolve or Pause IRS Collections Before Settlement Funds Arrive
The IRS is prevented from seizing funds when you maintain an active payment arrangement, have been granted Currently Not Collectible (CNC) status, have an Offer in Compromise under review, or are protected by bankruptcy proceedings. Stopping IRS collection activity before your settlement arrives frequently represents the most successful approach.
Negotiate an Affordable Payment Plan
By setting up a manageable payment plan early, you may prevent levies and protect your funds. Even modest installment plans can halt aggressive collection efforts.
Apply for an Offer in Compromise
An Offer in Compromise allows eligible taxpayers to settle tax debt for less than the full amount. If the offer is pending while the settlement is issued, the IRS may suspend levy actions.
Request Currently Not Collectible (CNC) Status
If you cannot afford basic living expenses, the IRS may temporarily halt collections. While interest continues to accrue, the IRS will not levy your settlement while you are in CNC status. This is especially helpful for individuals waiting for settlement funds after injuries or financial hardship. Learn more about Currently Not Collectible status.
Keep Settlement Funds Separate
When exempt money is mixed together with other funds, demonstrating that it cannot be collected becomes challenging. Numerous legal professionals advise maintaining a separate account or trust account specifically for settlement payments to enhance legal safeguards.
Document Every Component of the Settlement
A well-documented settlement agreement that clearly specifies which portions are taxable versus exempt, details punitive damage allocations, medical expense reimbursements, how emotional distress is categorized, and breaks down attorney fees provides stronger evidence when challenging incorrect IRS collection efforts.
What To Do if the IRS Has Already Seized Your Settlement
Even following a levy, there may be opportunities to reclaim funds that were incorrectly taken. Submitting an appeal, requesting a Collection Due Process Hearing, providing proof that funds are exempt, or working out a payment arrangement can occasionally lead to the IRS returning the seized money. Taking immediate action is essential to avoid permanent forfeiture.
The IRS has the power to collect various types of settlements, especially taxable compensation such as back pay, punitive damage awards, and emotional distress payments not tied to physical harm. Personal injury settlements, workers' compensation benefits, and compensatory wrongful death awards typically receive greater protection.
Frequently Asked Questions
Tax Help for Those Who Owe
Learning how the IRS categorizes settlements, preparing in advance to address tax obligations, and maintaining thorough records of every settlement element can substantially lower the likelihood of collection. Taking prompt action is critical; while the IRS possesses strong collection capabilities, you also have legal protections and methods available to safeguard your financial recovery.
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