Settlement Taxation

Taxpayers are sometimes surprised that they are obliged to pay taxes on lawsuit settlement. Some don’t realize this until they receive tax forms the year following the settlement. Many of our clients approach us with specific questions regarding settlement taxes. We have summarized the most common questions and here are what you need to know.

Do I have to pay taxes on a lawsuit settlement?

Taxes depend on the nature of the claim. As a general rule, stated by Internal Revenue Code (IRC) Section 61, all income is taxable “unless a specific exception exists from whatever source derived unless exempted by another section of the code.”

How do I know if I am subject to tax liability?

There are several common scenarios that stem, as already mentioned above, from origin of the claim.

Personal injury and sickness settlements

As a general rule, personal injury and sickness settlements are tax-free under IRC Section 104. However, if you deducted any of your medical expenses in previous years, you must report settlement funds as income. The IRS won’t allow you to use the same tax break twice.

Compensation for emotional distress

As a general rule, compensation for emotional distress is taxed unless it is caused by a personal physical injury or physical sickness.

Back pay recovery

Back pay (includes lost wages, wrongful termination, severance and etc.) will be treated as ordinary income and taxed accordingly.

Punitive damages and interest

Punitive damages and interest are subject to income tax under the Internal Revenue Code and the Treasury Regulations.

Recovery of attorney fees (also known as contingency fees)

Starting from 2018, attorneys’ fees are no longer deductible due to taxation requirements changes brought by the Tax Cut and Jobs Act (TCJA). This means, that as a general rule, you must pay taxes on all income from the settlement agreement, even on amounts paid to a lawyer that you might never see.

However, there few exceptions that stem from the nature of a claim. For example, civil rights claim within the definition of “unlawful discrimination” allows deduction for attorney’s fees.

Loss-in-value of property

Settlement resulting from a loss of property will be a subject to tax if it’s worth more than the property basis. In this case, you must pay tax only on the excess. The settlement won’t be taxable if the worth is less than the property’s worth. In this case, it reduces your cost basis.

Will I receive 1099?

You should get a Form 1099-MISC from the payer if you receive over $600 in a calendar year and the settlement money is taxable.

However, your settlement might come from back wages of a W-2 job then the income would be reported on a W-2, not a 1099-MISC.

Another situation is when you receive settlement interest. In this case, it is reported on a 1099-INT. 

It is important to remember that you can receive multiple IRS forms for the same legal settlement.

How can I minimize or even avoid paying settlement taxes?

Here are a few tips that can help you improve your settlement outcome from a tax perspective.

Negotiate a Form 1099 income before finalizing a settlement.

Before signing the settlement agreement, you should determine whether the defendant will issue a Form 1099. If so, make sure to negotiate the 1099 income to be a lower number than your actual settlement amount.

Allocate damages.

During settlement negotiations, discuss the allocation of a larger settlement to non-taxable categories such as physical injury and illness instead of emotional distress.

Classify your settlement reward.

Depending on the nature of your claim, the classification of your reward might vary. For instance, if you’ve sued over damage to your home or business, you may be able to classify your settlement as capital gain, resulting in a more favorable tax rate. Or your settlement can be eligible for tax basis recovery, which reduces your capital gain in the future.

Distribute payments over time.

Getting a sizable lump-sum taxable settlement can raise your income tax rate. You can lower your marginal tax rates by spreading your settlement payments across a number of years.

How can Dimov Tax Specialists help you?

It is not always easy to complete the above steps on your own, and this is why you need tax professionals such as CPAs and EAs to step in.

• We can assist you with a strategy to reduce your taxable income.
• We can determine whether you must pay taxes on your settlement and, if so, which forms you must complete.
• We can help you understand your tax liability and evaluate any W-2 or 1099 forms you may get.
• We are ready to collaborate with your attorney to get the greatest results for you.

Simply contact us below & we will be more than happy to assist you.