Posted by Larry Hurt

Five Rules All Lawyers and Clients Should Know about Taxes on Legal Settlements

Five Rules All Lawyers and Clients Should Know about Taxes on Legal Settlements

It is common for lawyers and clients to always settle disputes. This usually involves an exchange of money. And, almost any time when money changes hand, it usually involves tax, which can happen in many ways.

You could be unjustly fired, or someone gave you a fender bender, which could lead to settlement payments. Many people wonder if the settlement payment is taxable. Most of the time, it is; only that the tax situation could vary enormously. 

With the above in mind, here are various tax rules on settlements that lawyers and their clients must know. 

Judgments and Settlements are Taxed the Same Way

Whether you receive money to settle a case or you won a case, the same tax rule holds. Even though they are similar, you will have more chance to reduce taxes if you settle a case rather than go to court. 

Should there be an audit, you must come clean on what the case is on and what your claim is seeking. This usually involves the complaint, settlement agreement, the mode of payment that helped resolve the matter, IRS form W2, etc. How you address these issues determines how you will be taxed. 

Save taxes by Allocating Damages

There are usually multiple issues in any typical legal dispute. If your dispute, however, relates to single conduct, the entire settlement will likely involve numerous damages. This is why it is in the best interest of the involved parties to agree on the amount paid and tax implication. While the agreement is not binding on the court or the IRS, they cannot be ignored.

This is why it makes sense to group the total into various categories. There is a significant probability the IRS will respect this. 

Medical Expenses Are Tax-Free

Should your injury be emotional only, all medical expenses incurred are tax-free. Besides, the definition of medical expenses is liberal. The same way payment to a physical therapist qualifies payment to a counselor or a psychiatrist also qualifies.

If you have, however, deducted the medical expenses before and you were reimbursed the following year of the settlement of your suit, it is essential to pay tax on them. This is part of the tax benefit rule.

Prioritize Capital Gain rather than Ordinary Income 

Almost everything can be classified as income except suits for sickness or injuries. The way it is taxed, however, differs. For instance, a settlement from a lawsuit about a damaged warehouse can be classified as a capital gain. Long term capital gain enjoys a lower tax rate.

Besides the tax rate preference, the basis of your tax is also essential. This is your initial purchase price added to the cost of any improvement you made minus any depreciation. There are cases when your settlement might not be classified as income but recovery of basis.

Damage to your capital asset like your warehouse is a good example. If you are paid damages due to damages on this property, you are better off reducing your basis, rather than reporting the gain.

Considering the defense Pays 

Many times, it is the plaintiff and not the defendant that bears the mental burden of the tax. This, however, is not a license to ignore the defendant's perspective. When a defendant pays a settlement, they will like it deducted. A defendant engaged in trade or business will less likely be questioned since litigation can be classified as the cost of business. It is only some government fines that cannot be deducted. 

Even with these deduction rules for businesses, not everyone gets lucky. For suits related to investments, for instance, the deduction might only be restricted to investment income. In the case of personal suits, there might be no deductions at all for the defendant.

Concluding Remarks

Almost all court cases do trigger tax issues. Some people might consider an amicable resolution to the dispute in a bid to avoid the tax headache. This, however, does not pay any of the party – whether the counsel, defendant, or plaintiff. 

Before amicably resolving the dispute and appending your signature, consider the tax implications. Consider all tax languages now and be sure you are cleared on them. This is because you will have to face this the following tax year. 

Larry Hurt
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