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How Are Lawsuit Settlements Taxed?

How Are Lawsuit Settlements Taxed?

Taxes are generally complicated. Lawsuit settlements involve money and are not exempted from taxes, but the laws that govern them, just like all other taxes, lawsuit settlement taxes need some explanation. 

It is always a good idea to have a tax consultant handle your tax issues.


Are all lawsuits taxed?

When you are involved in a case in court and you are awarded some money, you may wonder if such income is taxable. Yes, it is. 

According to Section 61 of the tax code, all income is taxable. The law further adds that there may be exceptions to that provision, but other code sections must state those exemptions from taxes. Those exceptions cover some types of lawsuit settlements.

Most lawsuit settlements involving interests on monetary awards, defamation, libel, copyright infringements, and workplace infringements are taxed. In contrast, issues of lawsuit payments that involve life-threatening incidents and injuries are exempted.

So, as a general rule, most lawsuit settlements are taxed, except they are payments for compensation for physical injuries, infirmities, and life-threatening conditions. If you're expecting lawsuit settlements, you should get proper tax guidance from tax accountants before spending your payments so that you don't run into trouble with Uncle Sam.

If you file a lawsuit for money owed you for a job done and you are awarded your earnings, your taxes would be paid; most times, it would be withheld from your pay since it is more or less an income. It is regarded as an income and is taxable. It is also considered an income if you benefit from punitive damages awarded against a defendant. Even if the punitive damages are awarded for physical damage to the recipient, the IRS still considers it an income, and it is taxed. Also, any interests that accrue from the non-payment of settlements are taxed.

So, as you can see, the IRS considers lawsuit settlements as taxable income, except when they primarily involve injury settlements, hospital expenses, or payments for the trauma that involve medical expenses. But, if you already deducted the medical costs for your injuries while getting the treatment, then your damages and lawsuit settlements would be taxed, regardless of what kind of medical treatment it is.

You must also note that tax authorities do not recognize legal fees paid from your lawsuit settlement. So, no matter how much a lawyer gets from your payment, the IRS still taxes you for the total amount.


Minimizing taxes on lawsuit settlements

Now that you know the type of lawsuits that the IRS charges, there are some steps you can take to limit the amount payable. For example, you can negotiate that more payment is allocated to matters that are not taxable if your lawsuit involves medical issues. You can also arrange the amount given if the defendant issues a Form 1099 and make the income on the form to be smaller than your actual settlement amount. Of course, another option is to negotiate to spread your settlement over some time—that way, the amount payable is reduced.

Finally, if you're expecting a lawsuit settlement, remember that you will be moving up in the tax bracket, and you need to prepare ahead. If you're still confused about the eligibility of your lawsuit settlements for tax, please consult a tax advisor. You'll also get good advice on how to minimize the payable taxes.

So many people have had to dip into their savings to clear their tax debts because they weren't correctly advised on whether or not their lawsuit settlements were taxable. By the time they knew, it was too late. You can choose not to fall into that trap.  


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