How does the IRS know which lawsuit settlements to tax?

Question

A relative received a modest settlement. The judge who worked on the case gave a letter to him, and the letter was careful to specify that the settlement was for a physical injury. The IRS does not tax settlements for physical injuries.

He was told he will not receive any tax documentation for this settlement. He plans to not include it in his 2019 tax returns. From my limited understanding, having gone over some IRS rules, this seems all up-and-up. The question is, how does the IRS know not to come after him for taxes on this settlement? Who tells the IRS which settlements are to be taxed? Presumably no one. So will the IRS typically contact the person who received the settlement, and request evidence?

Answer 1

He was told he will not receive any tax documentation for this settlement.

This also means that the IRS will not receive any tax documentation for this settlement. Forms documenting taxable income, such as W-2 and 1099, are sent in duplicate (effectively) to the taxpayer and the IRS, and this is the primary way the IRS knows about income.

The IRS does not routinely see, or ask for explanation of, all deposits to bank accounts -- it would dig in this way only if investigating suspected fraud based on the information normally available to it. If he's subjected to a deep audit, then the letter might come in handy.

There are also other legitimate types of non-taxable deposit not reported to the IRS, such as gifts received.

The IRS is not an all-knowing big brother, just an agency with limited resources that tries to encourage payment of taxes owed, largely on the honor system.