Posted by Elliot Kravitz, ATP

The Five Main IRS Tax Rules for Legal Settlements

The Five Main IRS Tax Rules for Legal Settlements

Leaving the winning side of a lawsuit as a plaintiff can be a rewarding feeling, especially if it's a financial deal. There will likely be a sense of relief and demand. Unfortunately, people are often surprised when they realize that they have to pay premium taxes. You can also be taxed on your attorney's fees! However, tax planning can be beneficial, especially if you do it before the end of the contract, and the concession is substantial. 

Top five rules you need to know to make the right decision

    •    Legal fees: Applicants who hire a lawyer for potential expenses generally pay taxes when they receive 100% of the money recovered. This means that you also have to pay taxes for part of the settlement that lawyers have in the form of commissions. This is always the case, even if their potential fees are paid directly by the defendant. In obvious cases of personal injury in which the entire settlement is not taxable, there is no problem, but if the first is taxable, special attention must be paid.

    •    An example of receiving a settlement paid for emotional distress, and you receive $ 350,000, with your lawyer getting about $ 105,000 (which accounts for 30% of the total settlement). If this is the situation, you will normally be liable for the amount of $ 350,000 and not only the tax of $ 245,000 that you maintain. To make matters worse, in addition to legal employment rates and some whistleblower complaints, there is no proper deduction for attorney fees. There are ways to mitigate it, but tax recommendations early in the process are crucial.

    •    Allocation Damages: Legal disputes usually involve more problems and more behavior. As a result, agreements generally have different types of considerations, each with potentially different tax treatments. If the plaintiff and the defendant accept the tax treatment before the end of the case, they can attribute the total damages to specific categories and save the taxes. Such agreements are not technically binding on the Internal Revenue Service but are rarely questioned.

    •    The origin of the Claim in the principal determines the tax consequences: The taxation of legal agreements is based on the source or the reason for the complaint. For example, if you win a claim for unfair dismissal against an employer, your premium will be taxed as wages and possibly as other income for what is attributed to emotional damage. On the other hand, if you sue the contractor who built your house for losses caused by his negligence, the settlement cannot be considered as income and can treat it as a reduction in the purchase price of the property. There are many exceptions in this area, and it always depends on the facts and the circumstances of the case.

    •    Physical injuries produce tax-free rewards, but emotional stress and injuries are taxable: Damages received for claims involving injury or illness are exempt from tax. A lawsuit for emotional stress and defamation is subject to taxes, including physical symptoms of psychological stress (gastrointestinal problems, etc.). Be careful, because the latter can be ambiguous; therefore, it is best to agree with the defendant on the nature of a physical symptom as a cause or result of emotional stress before the matter is finalized. 

    •    Punitive Damages and Interests: In general, punitive damages are always subject to tax. For example, take a case where you were injured in a car accident and receive $100,000 in compensatory damages and $ 4 million in punitive damages. $200,000 is tax-exempt, while $4 million is tax-exempt.

    •    is treated the same way. Even if you receive a non-taxable type of settlement, but it took a while to complete it through pre-processing or post-processing, the interest earned is taxable. Therefore, it is often beneficial to resolve a case, rather than take it to court, and having it go through judgment.

Bottom Line

The taxation of legal agreements and bonuses is differentiated and largely depends on the facts and circumstances of the case. However, there are many opportunities with proper tax planning to minimize the tax consequences, but only if you are proactive and plan.

Elliot Kravitz, ATP
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