Taxation of Lawsuit Recoveries: 10 Points of Law

  • The same tax rules apply whether the award is made by settlement (before or after lawsuit) or awarded through a judgment. But the parties can influence taxation by inserting pivotal facts in a settlement agreement. For example, allocating damages and specifying 1099 obligations are two ways to influence taxation through a settlement agreement.

  • Settlements and awards are taxed based on the “origin of the claim” (i.e. what the lawsuit seeks compensation for). For example, lost profits or wages will be taxed as ordinary income. But damages caused by a negligent destruction to your home may be considered a reduction of the purchase price.

  • As to recoveries for personal injuries, only those for physical injuries or physical sickness are considered tax-free (IRC § 104). Although there is some wiggle room here, observable physical harm (cuts, bruises, or disfigurements) qualify while emotional distress does not. Consider a tax-savvy settlement agreement that references compensation for physical injuries. For example, did your emotionally abusive employer cause you to experience tension headaches that resulted in a higher recovery? Spell that out in the settlement agreement, and secure the defendant’s promise not to issue a 1099-MISC. for that additional amount.

  • Allocating settlement payments and their corresponding tax treatment may prove effective at convincing the IRS of your designated tax treatment. These types of allocations are not binding upon the IRS but are usually considered.

  • Medical expenses (even for emotional injury) are tax free. Such expenses include fees to a psychiatrist, counselor, chiropractor, or a physical therapist.

  • Even if all or part of the award is considered taxable income, consider the character of the income. Does the award redress damage to your home or business premises, which may be classified at the lower capital gains rate? Or maybe damage to your factory can be applied to reduce basis (investment cost) rather than be taxed as gain.

  • The Tax Cuts and Jobs Act wiped out the miscellaneous itemized deduction for attorneys’ fees in taxable recoveries. Now, the individual who hires a contingency-fee lawyer to recover money for emotional distress will be taxed on 100% of the recovery. Narrow exceptions to this rule apply, such as businesses deducting those legal fees as business expenses, or claims brought by employees or whistleblowers. Tax experts say that the nondeductibility of legal fees for taxable awards will catch many by surprise.

  • Punitive damages and interest on damages are always taxable, regardless if the underlying claim was for physical injuries. Even prejudgment interest on an otherwise tax-free award will be taxable.

  • Under the Tax Cuts and Jobs Act, in confidential sexual harassment or abuse cases, the defendant may not deduct the settlement or its attorneys’ fees. But the way the law is currently written, the plaintiff may not deduct attorneys’ fees either. Before the Tax Act, an employee-plaintiff’s legal fees for harassment would be an above-the-line deduction. Measures to correct this apparent error are underway.

Consulting a competent tax lawyer early is the name of the game. I would love to discuss the specifics of your case.

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