Key Takeaways
- The IRS can seize or levy settlement funds if you owe back taxes, but the risk depends on the type of settlement and whether it is taxable.
- Personal injury, workers’ compensation, and compensatory wrongful death settlements are generally more protected from IRS seizure, while employment-related, punitive damages, and non-physical emotional distress awards are highly vulnerable.
- Taxable components of a settlement, such as lost wages, interest, and certain attorney fees, are most likely to be seized, especially if funds are deposited in a bank account under levy.
- IRS collection tools include bank levies, wage levies, and direct levies to attorneys or insurers, which can intercept settlement money before it reaches the taxpayer.
- Proactive strategies like establishing a payment plan, applying for an Offer in Compromise, requesting Currently Not Collectible (CNC) status, keeping settlement funds separate, and documenting each component can help protect your settlement.
- Acting early and consulting a tax professional is crucial; properly classifying taxable versus non-taxable portions and coordinating with your attorney can significantly reduce the risk of IRS seizure.
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.
However, the long answer is far more nuanced. Not all settlements can be seized, not all are taxed the same way, and several protections, including state exemptions, federal limits, and specific tax codes, may apply. Understanding these rules can help you anticipate what portion of your settlement is at risk and what strategies you may use to protect it.
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.
Understanding Whether the IRS Can Seize a Settlement
Before diving into the different types of settlements, it’s crucial to understand the IRS’s authority. When you owe back taxes, the IRS has broad legal power to collect the debt. This includes the ability to levy wages, bank accounts, Social Security benefits, business income, property, and yes, settlement payments.
However, the amount the IRS can seize and which settlement types they can take depend on federal law, state exemptions, and how the settlement is categorized. Understanding these distinctions is your first line of defense.
How the IRS Classifies Settlements for Tax and Levy Purposes
Settlement payments are not all treated equally. The IRS evaluates what the settlement represents, whether it is taxable, whether you currently owe federal tax debt, where the settlement is being deposited, and how accessible the funds are.
Taxable vs. Non-Taxable Settlement Components
Most settlements have multiple components that may be treated differently for tax purposes. Some parts may be exempt from income tax, while others are fully taxable and the IRS can levy the taxable portion. Taxable components often include lost wages, interest, punitive damages, emotional distress not linked to a physical injury, and certain portions of attorney fees. Non-taxable components generally include compensation for physical injuries or sickness, reimbursements for medical expenses not previously deducted, and some wrongful death settlements. Non-taxable components are typically protected from levy, but taxable portions are vulnerable.
Why the Classification Matters for IRS Seizures
The IRS typically assumes that mixed settlements are taxable unless you provide documentation showing otherwise. This makes detailed settlement breakdowns essential. If you fail to classify the settlement properly, even exempt portions may be treated as available for collection, especially if they are commingled in a bank account.
When the IRS Can Legally Seize a Settlement
Immediately after a settlement is issued, the IRS can generally seize any portion considered taxable, any funds deposited into a bank account subject to a levy, and any settlement paid directly to you while a levy or garnishment is active. However, the IRS cannot seize funds if doing so violates specific federal exemptions or court orders.
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 generally cannot seize compensation for physical injuries, pain and suffering linked to the injury, or medical reimbursements for expenses that were not previously deducted. These are considered compensatory, non-taxable damages and are usually shielded from collection.
Portions That Are Vulnerable to IRS Levy
Even in personal injury cases, the IRS may levy punitive damages, attorney fees in specific claim types, interest on the settlement, damages for non-physical emotional distress, and lost wages included in the award.
For example, if you were awarded $150,000 for injuries and $30,000 for lost wages, the IRS cannot touch the $150,000, but the $30,000 portion is considered taxable and may be seized.
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
Most compensatory damages, such as compensation for loss of life, funeral expenses, loss of consortium, and non-economic losses tied to the death, are typically non-taxable and therefore shielded from IRS seizure. Wrongful death settlements also are the exception where punitive damages are non-taxable.
Portions That May Be Seized
The IRS may still levy interest on the settlement, or attorney fee allocations, depending on the state and claim. Proper documentation of each component in the settlement is crucial to prevent improper levy.
Employment-Related Settlements
Settlements arising from employment disputes are among the most vulnerable to IRS seizure. Awards for wrongful termination, unpaid wages, back pay, front pay, lost benefits, and claims for discrimination or harassment are generally treated as taxable income. Because they are considered income, the IRS can levy them before you ever receive the funds.
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
In rare cases, emotional distress awards linked to a physical injury may be non-taxable, but most employment settlements include large taxable portions. Documentation is key to separating these amounts.
How the IRS Seizes Settlement Funds
Understanding IRS collection mechanics can help you anticipate and respond to actions against your settlement.
IRS Bank Levies on Settlement Deposits
If your bank account is under levy, the IRS can seize the amount available in the account, including newly deposited settlement funds. Once the funds are in the account, they are no longer shielded unless you can prove they are exempt.
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 can issue a levy directly to the attorney handling the settlement, the insurance carrier, or the settlement administrator. Once notified, these parties are legally obligated to send the seized funds directly to the IRS. Attorneys cannot release these funds to you without risking legal liability.
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
If you owe back taxes and anticipate receiving a settlement, taking proactive steps can preserve a significant portion of your payout.
Resolve or Pause IRS Collections Before Settlement Funds Arrive
The IRS cannot levy funds if you have an active payment plan, are approved for Currently Not Collectible (CNC) status, have a pending Offer in Compromise, or are in bankruptcy protection. Pausing IRS action before receiving the settlement is often the most effective strategy.
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.
Keep Settlement Funds Separate
When exempt funds are commingled with other money, proving they cannot be levied becomes difficult. Many attorneys recommend using a separate account or trust account for settlement proceeds to strengthen legal protection.
Document Every Component of the Settlement
A clear settlement agreement that outlines taxable and non-taxable portions, punitive damages, medical reimbursements, emotional distress classification, and attorney fee breakdowns strengthens arguments against improper IRS levy attempts.
What To Do if the IRS Has Already Seized Your Settlement
Even after a levy occurs, you may be able to recover improperly seized funds. Filing an appeal, requesting a Collection Due Process Hearing, showing documentation of exempt funds, or negotiating a payment agreement can sometimes result in the IRS releasing the seized funds. Acting quickly is critical to prevent permanent loss.
The IRS can seize many types of settlements, particularly taxable awards like lost wages, punitive damages, and non-physical emotional distress damages. Personal injury settlements, workers’ compensation, and compensatory wrongful death awards are generally more protected.
Frequently Asked Questions
Can the IRS take money from a lawsuit settlement?
Yes, the IRS can seize or levy portions of a lawsuit settlement if you owe federal tax debt. Taxable components such as lost wages, punitive damages, and certain attorney fees are most at risk, while non-taxable portions like compensatory personal injury awards are generally protected.
What can the IRS not seize?
The IRS cannot seize funds that are legally exempt, including certain non-taxable personal injury awards, workers’ compensation benefits, and some property protected by state or federal law. Exempt retirement accounts and Social Security benefits may also be partially or fully protected.
How much can the IRS legally garnish?
There is no fixed percentage for garnishing settlements, but the IRS can levy enough to satisfy the outstanding tax debt, including penalties and interest. They typically target taxable income first and may seize bank deposits, wages, or settlement proceeds to cover the full amount owed.
How can I protect my settlement from IRS collection?
To protect a settlement, you can establish a payment plan, request Currently Not Collectible status, apply for an Offer in Compromise, keep exempt funds in a separate account, and maintain detailed documentation of taxable and non-taxable components. Early action and coordination with a tax professional and your attorney are crucial for safeguarding your settlement.
Tax Help for Those Who Owe
Understanding how the IRS classifies settlements, planning ahead to resolve tax debts, and documenting each settlement component can significantly reduce the risk of seizure. Early action is essential; the IRS has powerful collection tools, but you have rights and strategies to protect your financial recovery. Optima Tax Relief is the nation’s leading tax resolution firm with over a decade of experience helping taxpayers.
If You Need Tax Help, Contact Us Today for a Free Consultation