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Tax Implications of a Legal Settlement: Everything You Need to Know

Tax Implications of a Legal Settlement: Everything You Need to Know

After winning a lawsuit or getting a settlement, many people are surprised that they have to pay taxes on what they win. Some people don't realize this until they receive Form 1099 at tax time. It is important to know that tax planning goes a long way, especially before you settle.

Note that it may be taxable income before you spend your settlement, according to the IRS. 

Do you have to pay settlement fees?

The simple answer is yes. Collecting a large sum of money without at least notifying the IRS is not legal. In many cases, they will also ask for a share of the profits.

According to the IRS tax code, the only damages exempt from tax are those resulting from injury or illness. If so, you probably won't have to worry about the Internal Revenue Service wanting some of your money.

In addition to compensation for bodily injury or illness, monetary damages may also be awarded for other reasons. For example, let's say you won a discrimination lawsuit against your former employer. As a result, you receive compensation and back pay for emotional distress. This award is taxable at the normal income rate because it is unrelated to bodily injury.

Punitive damages are another type of compensation intended to punish the defendant. The damages are almost always taxable whether the underlying case stems from injury or illness.

But the Internal Revenue Service may surprise you in another way. You may be in a high tax bracket if you receive a lump sum payment. This means higher taxes.

You can benefit from hiring an accountant in the tax year you receive your return, even if you normally do your taxes. It can be difficult to know which parts of a court settlement are subject to taxation by the IRS.

How taxes on lawsuit works

The tax burden of a court transaction depends on the type of transaction. Bodily injury is generally not taxable. However, you will have to pay taxes for your injury if you have already claimed medical expenses. You cannot get the same tax relief twice.

Some non-physical suits may result in damage or physical injury. When someone wins a libel suit and receives compensation for the doctors they saw for stress-related headaches after being slandered, those damages are not taxable, provided you don't already have them deducted from your taxes. Although emotional injuries are generally chargeable, there is an exception if the emotional distress is a result of a physical injury or manifests in physical symptoms for which treatment is sought.

Punitive damages, as well as late payment and interest on unpaid amounts, are generally taxable. Damages for emotional distress are also taxable, but with exceptions which are listed above. You owe taxes on the total amount you receive, including attorney's fees. In addition, if the opposing party is required to pay attorneys' fees, these fees will also be taxable. In some types of lawsuits, you may be able to deduct attorney's fees.

Taxable Lawsuit Settlements

Back Pay

Let's say you filed a claim for back pay from a W-2 job. This would be considered ordinary income.

You will receive a W-2 for this, and income taxes and FICA will be withheld. When it comes to taxes, your settlement is quite similar to a regular salary.

Think of it as income that you should have earned in the first place. You will therefore be taxed as if you had received the income during this period.

Punitive Damages

Punitive damages may be assessed if they seek to punish a defendant for wrongful conduct. This also applies if you receive them on your personal injury settlement.

Settlement Interest

This is interest on an unpaid settlement; hence, why it is called settlement interest.

In addition to prejudgment interest, which accrues between the time of injury and the time of trial, you may also see post-judgment interest. Interest from post-judgment is payable.

Both types are taxable to the beneficiary.

Tax-Free Lawsuit Settlements

Settlement for medical expenses

If the settlement proceeds are used for medical expenses, they will not be taxed. This is true even if the income comes from emotional injury.

Personal injury settlements

Most times, the proceeds of a bodily injury settlement are not taxed.

Non-taxable compensation is available for physical and mental injuries. Whenever a person suffers a bodily injury or illness due to another party's negligence, they are entitled to tax-free compensation for their pain, suffering, and emotional distress.

Pain and Suffering

In many states, a settlement from a personal injury does not tax pain, suffering, and emotional distress caused by physical injury or illness.

However, if there are no physical injuries and the claim is based solely on mental or emotional distress, the state and the IRS will likely tax those damages.

Are class action lawsuit settlements taxable?

Often, the nature of a class action decides whether the settlement can be encumbered. The proceeds of a class action settlement are taxable in situations where there is no physical injury, discrimination of any kind, loss of income, or impairment of an investment.

How attorney fees are taxed in lawsuit settlements

Suppose you are the plaintiff and hire a contingency fee attorney. In that case, you will be taxed on receiving 100% of the money recovered from you and the attorney, even if the defendant pays your attorney directly for contingency fees. This shouldn't cause any tax problems if your case is nontaxable. But, if you recover taxable damages, be careful.

Imagine you settle a case of intentional infliction of emotional distress on your neighbor for $10,000, and your attorney keeps $2,000. You might think that would equal $8,000 in income for you. But in the eyes of Uncle Sam, the amount you earned is still $10,000.

Can attorney's fees be deducted? The tax reform adopted at the end of 2017 includes a new litigation settlement, which means that legal fees are not tax deductible. This is a particularly strange and unpleasant surprise for taxpayers. Therefore, tax advice is essential before signing a settlement agreement and settling the case.

1099-MISC for legal settlement

You may receive Form 1099-MISC if you receive a taxable settlement. The Form 1099-MISC is used to report all types of different income, including court settlements.

You must report settlement income in box 3, "Other income."

When would you get a 1099-MISC for legal settlement?

The Internal Revenue Service requires the taxpayer to send the recipient a 1099-MISC as long as these requirements are met:

  • The beneficiary received more than $600 in a calendar year

  • The settlement money is taxable

You will not receive a 1099 for a legal settlement representing non-taxable income, such as bodily injury.

Some exceptions also apply to taxed settlements. If your settlement included back pay from a W-2 job, you would not receive a 1099-MISC for this part. Instead of 1099, the funds would be included in a W-2.



Pat Raskob
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