Navigating Stimulus Checks After a Lawsuit Settlement: A Comprehensive Guide for Settlement Recipients

For individuals who have recently navigated the complex and often emotionally taxing journey of a lawsuit, receiving a settlement can represent a pivotal moment. Whether it’s compensation for personal injury, a dispute over employment, or any other legal resolution, a settlement often brings a sense of closure and financial relief. However, in the wake of the various economic impact payments – commonly known as stimulus checks – issued by the U.S. government, a new set of questions may arise: How does my lawsuit settlement affect my eligibility for these payments? Will it count as income? What if I received a large sum?

This article aims to demystify the intersection of lawsuit settlements and stimulus check eligibility, providing a comprehensive guide for those who have received a legal settlement.

Understanding the Stimulus Check Basics

Before delving into the specifics of settlements, it’s crucial to briefly recap the general criteria for stimulus checks. The U.S. government authorized several rounds of Economic Impact Payments (EIPs) primarily to provide financial relief during the COVID-19 pandemic. While the specific amounts and rules varied slightly between rounds, the core eligibility criteria revolved around two main factors:

1. Adjusted Gross Income (AGI): This is a key figure from your tax return, calculated by taking your gross income and subtracting certain deductions (like IRA contributions, student loan interest, etc.). Each stimulus payment had AGI thresholds, above which the payment would be reduced or phased out entirely.
2. Dependents: Additional amounts were typically provided for qualifying children or other dependents.
3. Social Security Number (SSN): Generally, recipients and their qualifying dependents needed a valid SSN.

The IRS primarily based eligibility on your AGI from your most recent tax return on file at the time of payment processing – typically your 2018 or 2019 return for the first two rounds, and your 2019 or 2020 return for the third round. This "lookback" rule is critical for settlement recipients, as we’ll explore.

Lawsuit Settlements: Understanding Their Taxable Nature

The most critical factor in determining how a lawsuit settlement impacts your stimulus check eligibility is its tax treatment. Not all settlement money is taxed the same way, and some isn’t taxed at all. The IRS differentiates between various types of damages awarded in a settlement:

1. Physical Injury or Physical Sickness Settlements (Generally Non-Taxable):

   • Key Principle: Under Internal Revenue Code Section 104(a)(2), gross income does not include the amount of any damages (other than punitive damages) received on account of personal physical injuries or physical sickness.
   • Examples: Compensation for medical expenses, lost wages directly attributable to the physical injury/sickness, pain and suffering, and emotional distress directly linked to the physical injury are typically non-taxable.
   • Implication: If your settlement falls into this category, it generally will not increase your Adjusted Gross Income (AGI) for tax purposes.

2. Emotional Distress Settlements (Often Taxable, Unless Linked to Physical Injury):

   • Key Principle: If the emotional distress is not a result of a physical injury or physical sickness, then the portion of the settlement attributed to emotional distress is generally taxable.
   • Examples: Compensation for emotional distress in a defamation lawsuit (where no physical injury occurred), or a standalone emotional distress claim.
   • Implication: This portion would increase your AGI.

3. Lost Wages, Back Pay, or Lost Profits (Generally Taxable):

   • Key Principle: Income that replaces wages, salaries, or business profits that would have been earned is generally taxable.
   • Examples: Compensation for lost income due to wrongful termination, breach of contract, or business interruption.
   • Implication: This portion would increase your AGI.

4. Punitive Damages (Always Taxable):

   • Key Principle: Punitive damages are awarded to punish the wrongdoer and deter similar conduct, not to compensate for losses. The IRS considers these taxable income, regardless of the nature of the underlying injury.
   • Implication: This portion would increase your AGI.

5. Interest on Damages (Always Taxable):

   • Key Principle: Any interest awarded on a settlement, whether pre-judgment or post-judgment interest, is considered taxable income.
   • Implication: This portion would increase your AGI.

6. Legal Fees:

   • Key Principle: How legal fees impact your taxable income can be complex. In some cases, if the settlement is taxable, you might be able to deduct legal fees as an itemized deduction (though this is subject to limitations, especially after the Tax Cuts and Jobs Act of 2017 for individuals). For non-taxable settlements, the fees don’t impact your taxable income.

Crucial Point: Your settlement agreement should clearly delineate which portions of the settlement are for what purpose. It’s essential to review this document carefully, and ideally, your attorney should provide you with a breakdown of the settlement components and their tax implications.

How Settlements Impact Stimulus Eligibility: The AGI Connection

Now, let’s tie this back to stimulus checks. The direct impact of your settlement on your stimulus eligibility hinges entirely on whether the settlement amount, or a portion of it, is considered taxable income and thus contributes to your AGI.

• Non-Taxable Settlements (e.g., Physical Injury): If your settlement was solely for physical injuries or illness and did not include taxable components like punitive damages or lost wages, it will not increase your AGI. Therefore, such a settlement would not negatively affect your stimulus check eligibility. Your AGI from the relevant tax year would remain unaffected by the settlement proceeds.

• Taxable Settlements (e.g., Lost Wages, Punitive Damages): If your settlement included components that are considered taxable income (e.g., lost wages, emotional distress not tied to physical injury, punitive damages), these amounts would increase your AGI for the tax year in which they are received.

The "Lookback" Rule: Why Timing Matters

This is where the timing of your settlement becomes paramount. Remember, the IRS used your AGI from a previous tax year (2018/2019 for the first two rounds, 2019/2020 for the third) to determine your stimulus eligibility.

Scenario 1: You Received a Non-Taxable Settlement in 2020 or 2021.

• Impact: Your AGI for 2020 or 2021 would not be impacted by this settlement. Your stimulus eligibility would be based on your prior-year tax returns (2019 or 2020), which would not reflect the settlement income. In this common scenario, the settlement would have no bearing on your stimulus checks.

Scenario 2: You Received a Taxable Settlement in 2019.

• Impact: If you received a significant taxable settlement in 2019, it would have increased your 2019 AGI. When the IRS used your 2019 tax return for the first two stimulus checks, a higher AGI might have reduced or eliminated your eligibility, even if your income in 2018 (which was also used) was lower.

Scenario 3: You Received a Taxable Settlement in 2020.

• Impact: A taxable settlement in 2020 would have increased your 2020 AGI. For the third stimulus check (issued in 2021), the IRS would have looked at your 2019 or 2020 return. If your 2020 AGI (including the taxable settlement) was higher than your 2019 AGI, and crossed the phase-out thresholds, your third stimulus check might have been reduced or denied.

Scenario 4: You Received a Taxable Settlement in 2021.

• Impact: A taxable settlement in 2021 would have increased your 2021 AGI. The stimulus checks were generally distributed based on 2019/2020 AGI. Therefore, a taxable settlement received in 2021 would not have impacted the initial distribution of any of the three stimulus checks. However, if you claim a Recovery Rebate Credit on your 2021 tax return (for any missed stimulus payments), your 2021 AGI would be used to determine your final eligibility for that credit. If the 2021 taxable settlement pushed your AGI above the thresholds, you might not be eligible for the credit, even if you were eligible based on prior years’ income.

What If You Didn’t Receive Your Stimulus, But Believe You’re Eligible?

Many individuals, including some settlement recipients, may have been eligible for stimulus payments but never received them, or received less than the full amount. This can happen for various reasons, including:

• IRS had outdated information: Your address or bank account details may have changed.
• Eligibility changed: Your income decreased, or you added a dependent in a later year than the one the IRS used for initial payment.
• No tax return filed: You may not typically file a tax return because your income is below the filing threshold.

If you believe you were eligible for a stimulus payment (or a larger amount) for the 2020 or 2021 tax years, but did not receive it, you can claim the Recovery Rebate Credit when you file your federal income tax return.

• For 2020 stimulus payments: Claim on your 2020 tax return (if you haven’t filed it yet, or amend if you did).
• For 2021 stimulus payments: Claim on your 2021 tax return.

When you claim the Recovery Rebate Credit, your actual AGI for the year for which you’re claiming the credit (e.g., 2020 AGI for the 2020 credit) will be used to determine your eligibility. This means if you had a taxable settlement in that specific year that pushed your AGI over the threshold, it could affect your eligibility for the Recovery Rebate Credit.

Beyond the Check: Important Considerations for Settlement Recipients

Receiving a lawsuit settlement, especially a substantial one, can have broader financial implications beyond just stimulus checks.

• Consult a Tax Professional: This is arguably the most crucial piece of advice. Tax law surrounding lawsuit settlements is complex and highly fact-specific. A qualified tax advisor (CPA, Enrolled Agent, or tax attorney) can:
  • Help you understand the precise tax implications of your specific settlement agreement.
  • Advise on how to properly report taxable portions of your settlement.
  • Assist with any questions regarding your stimulus eligibility and the Recovery Rebate Credit.
  • Help with estimated tax payments if your taxable settlement is significant.
• Keep Meticulous Records: Retain all documentation related to your lawsuit and settlement, including the settlement agreement, any court orders, and correspondence with your attorney. This will be invaluable if you ever face questions from the IRS.
• Financial Planning: A large settlement, whether taxable or not, presents a significant financial opportunity. Consider working with a financial planner to:
  • Create a budget and long-term financial plan.
  • Invest the funds wisely.
  • Address any outstanding debts.
  • Plan for future needs, such as retirement or education.
• Beware of Scams: Be vigilant against scams related to stimulus checks or your settlement. The IRS will never contact you by phone, email, text, or social media asking for personal or financial information to send you a payment.

Conclusion

For individuals who have received a lawsuit settlement, understanding its impact on stimulus check eligibility hinges on one primary factor: whether the settlement, or a portion of it, is considered taxable income. Settlements for physical injuries or illness are generally non-taxable and will not affect your Adjusted Gross Income, thus having no bearing on your stimulus eligibility. However, portions of settlements for lost wages, punitive damages, or emotional distress (not tied to physical injury) are taxable and could impact your AGI, potentially affecting your stimulus payment or Recovery Rebate Credit, depending on the tax year in which the settlement was received.

Given the complexities of tax law and individual circumstances, the best course of action is always to consult with a qualified tax professional. They can provide personalized advice to ensure you accurately report your income, claim all eligible credits, and navigate your post-settlement financial landscape with confidence.