Posted by Schneiderman and Friedman

Tax Implications of a Legal Settlement

Tax Implications of a Legal Settlement

When two parties agree on something concerning a case, they settle. In this case, the defendant will pay an agreed sum of money to the plaintiff. The plaintiff, in many cases, could collect the money and move on. 

There are, however, cases when one needs to pay taxes depending on the type of issue. As a result, one needs to be aware of specific tax guidelines to avoid surprises during the tax period. These rules can guide you on how to start, although; you still need a tax professional's assistance to guide you. 

Estimating the Taxation of a Legal Settlement 

The IRS taxes a settlement payment based on the nature of the claim that warranted the payment. All cases have unique properties, and the reason for the payment is also called the "origin of the claim." The reason behind the claim, most times, relies on the circumstances and exact facts that surround the case.

A settlement payment that will come from employment related claims, for instance, might involve wages not claimed. The IRS can tax this as ordinary income. When you receive the settlement proceeds, the IRS views them as getting the wages owed. 

Suppose a careless contracting company damages your house, which warranted a settlement payment. In that case, there is a big chance the payment from this incident will be classified as repayment for the asset destroyed. This is not the same as ordinary income, which removes the tax.

Most times, the IRS considers a settlement payment as taxable income. However, an exemption to this rule is when the settlement involved is compensation for injuries.

Will Uncle Sam Expect Taxes from Personal Settlement?

One might have a physical injury due to an accident, slip, and fall, etc. The IRS cannot tax the compensation that comes from the settlement case.

Many might consider this rule odd because generally, settlement proceeds from personal injury cases do come with reimbursement for losses that arise, which would have been taxable with emotional distress claims. 

In any case, if the origin of the claim hinges on a personal injury or sickness that is physical, there are some parts of the IRS tax code, which helps protect settlement compensation for the illness or injury from tax. (Section 104).

One might want to know the meaning of a "physical" injury when it comes to determining if this settlement will be tax-free. While there has not been a clear definition from the IRS, they reveal that the damage must reveal physical body harm for it to be classified as physical. 

However, the issue of sexual harassment is peculiar as the court is yet to agree if the claim elements like inappropriate and unwanted touching can trigger a physical injury, which the tax rule covers. 

Settlement of Emotional Distress: Taxes

One needs to understand that Uncle Sam's standard for physical harm in a suit for personal injury makes a difference between emotional anguish and claims for bodily injury. Settlement targeted at emotional distress will be taxed, unlike lawsuits from a physical injury. 

Based on this rule, there are some differences between visible emotional distress signs (like insomnia, nausea, and headaches) alongside sickness. 

Factors that Affect Settlement Taxes 

Besides emotional distress, there are other lawsuit factors that one will involve in the settlement, which will warrant a tax. Examples are:

  • Punitive damages

  • Settlement proceeds that come from non-injury claims

  • Attorney fees for a taxable claim

Non-Injury Claim Settlement 

Claims for non-injury like a breach of contract will be subjected to taxes provided that the payout and claim hinge on them. For instance, should you develop physical illness from each deal, you will pay tax from such settlement proceeds. 

Case Interest 

In many states, they will add interest to the verdict for the period that the payment is on hold. The IRS, in this case, will tax the interest amount. For instance, a plaintiff might be successful with a case and will get a verdict. The defendant could appeal, which will pause any settlement payment. 

When it is time for the defendant to pay, interest was calculated from the time of award of the verdict, which was left unpaid due to the appeals. Generally, the plaintiff will pay the tax for the interest amount calculated through time.



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