The Tax Impact of Your Lawsuit: What You Should Be Aware Of

Money From Suits You Have To Claim As Taxable vs Non-Taxable Dollars

There is a lot of confusion about the difference between whether a settlement is taxable or not and the difference as it relates to whether you must report the money from a settlement as income.
The good news is that most of the time, settlements are not taxable, but sometimes they are. The best place to look for guidance on the taxation of a settlement is IRS Revenue Ruling 85-7. According to that ruling, there are three kinds of damages in a lawsuit. The first are those that are paid to compensate for physical injury or sickness, including items for medical expenses. These are not taxable. The second kind of damages are punitive damages. These are always taxable and need to be reported as income. Damages from defamation, slander, or libel are an example of the third type of damages and are always taxable. All of this can get rather confusing, however, and can depend on how you have the settlement allocated. One of the more important things to remember about this is that under the law, you need to allocate every payment you receive from a settlement to the damages categories authorized in the United States tax code. In other words, a settlement check for $250 , 000 needs to have all $250,000 account for the damages items to which it relates. Every single one must be accounted for. If there is any section of the settlement amount that is not allocated, then it is deemed by the IRS to be income and should be taxed accordingly. The IRS does not like to spend money to prosecute people for tax fraud. In fact, it only brings a few thousand cases against people a year for such fraud. Since the tax code by itself is so complicated, the IRS never has to pursue many people because they just cannot understand it. If you decide that you don’t need any legal help with this issue, then you must be prepared to incur heavy penalties for not accounting for all of your settlement money properly. While this may seem unfair to some people, the fact remains that the IRS merely looks for money to pay its budget. The Bottom Line is that you must account for everything. While I can’t make the tax laws easy to follow, I can assure you that I have spent years learning them, and help clients solve these kinds of issues every day. You are best served when you find some good legal advice on these issues, and you follow it.

Types of Damage Awards And Their Tax Status

When it comes to taxes, the treatment of lawsuit settlements depends on the type of damages that are paid. In general, compensatory damages that are awarded for physical damages such as lost income, pain and suffering, negligent medical care, and permanent injury are generally excludable from income. Punitive damages and compensatory damages related to physical damages are taxable. Emotional distress damages are also taxable, but recoveries for emotional distress in cases that did not involve a physical personal injury are fully taxable. In cases where damages for emotional distress are awarded separately from those for physical injuries, the amount for the emotional distress is fully taxable. In the case, though, where there are no physical or emotional distress damages, none of the damages would be taxable. Discrimination cases may be treated similarly or differently, depending on the remit of them. If the damages are truly on the merits of the case relating to discrimination, harassment, or retaliation, those should qualify for exclusion. However, the interests of the employer are also a factor in this; if the employer has an interest in excluding discrimination damages from taxable income even when the damages were substantially in excess of lost compensation or other economic losses, then there may be a disallowance of the exclusion. At the end of the day, in cases of lawsuit settlements, the type and amount of damages awarded for any purpose should always be carefully considered.

Tax Clauses In Settlement Agreements

In addition to agreeing on the amount paid in resolution of a lawsuit, the parties often focus on the written agreements regarding how the settlement payments will be reported for tax purposes. For example, under federal tax law, payments made in settlement of physical personal injury or physical sickness claims are excluded from gross income. Therefore, if a party receives a recovery of $100,000 in such a case, the party will not have tax liability on that amount. However, under federal and New Jersey tax law, punitive damages do not fall under that exclusion from gross income (and are included as income in any amount received). Therefore, it is important in settlements to have the agreement clearly delineate which portions of the settlement payment are being made for damages that fall under the exclusion from gross income, and which portions constitute non-physical injury or punitive damages that are included in the recipient’s income.
The above example is a simplistic one. There are many different settlement judgments and releases, complicated by the details of different types of possible claims. While no settlement agreement can guarantee a desired tax outcome, its terms may greatly influence how the Internal Revenue Service or the state taxing authority will treat the payments. Often, settlement agreements will not include express terms on tax treatment. Including specific tax treatment terms in an agreement can lead to more certainty for settlement recipients. However, in so doing, tax counsel must remain mindful of the possibility that a tax agency might seek to respect the written terms of the agreement, but find some provision unenforceable or contrary to public policy. In this respect, settlement agreements requiring a taxpayer to obtain advice from someone unless the advice is shown to be wrong or erroneous or containing anti-abuse language have been found unenforceable, but allowing the Internal Revenue Service to "disregard" an entire structure if IRS deems the structure to be an abusive tax shelter is acceptable.

Lawsuit Income on your Return

If your lawsuit settlement was reached through a Mediated Settlement Agreement or Consent Order you generally will not be required to pay income taxes on the proceeds received.
However, if your lawsuit was settled by means of a traditional civil complaint or awarded by a jury trial, the Internal Revenue Service (IRS) requires you declare your lawsuit settlement income on your tax return. If you do not declare your lawsuit settlement income your income taxes could be audited and you could be subject to penalties.
When a case is dismissed or settled by Consent Order you typically are not required to pay income taxes of "personal injuries or physical sickness." However, awards or settlements from an employment discrimination case could be taxable as wages, even if the dismissal was from a Mediated Settlement Agreement or Consent Order.
If you receive a single settlement check it is your responsibility to report the different "elements" of the settlement. For example, if you have a settlement check for $3,000 and part of the settlement covers lost wages and part of the settlement covers emotional distress you will break down the lawsuit settlement (i.e. lawsuit income) in order to determine which portion of your lawsuit settlement is taxable for both state and federal tax purposes.
If you have multiple elements associated with a lawsuit settlement the settlement often will provide an allocation of the elements, in other words the settlement payment is separated by what part of the settlement covers wages, what part of the settlement covers emotional distress, etc.; however, if the settlement payment fails to allocate the elements the taxpayer must determine the appropriate allocation of the lawsuit settlement income. Typically, litigants need to prove what a reasonable allocation would be to avoid paying excessive taxes on lawsuit settlement proceeds.
The most commonly used tax forms to report lawsuit settlements and judgments are the 1099-MISC form and DD-214 (for military discharge settlements). If you are not issued a 1099-MISC you will be required to report your lawsuit settlement as "other income" using IRS Schedule C: Profit or Loss from Business or Profession.
A lawsuit settlement is taxable if it is for lost wages or lost profits, or if a settlement purchase a specific property or asset. For example, if you received a lump sum settlement payment to cover loss of future earnings, this lawsuit settlement would be taxable on your tax return. However, an automobile accident settlement for alleged negligent damages is not taxable.

Minimizing The Tax You Pay On Settlements

One way of minimizing the tax bite of a settlement is to try to enter into a structured settlement agreement, which brings the greatest tax savings when the settlement is based on physical injury or sickness. A structured settlement is generally defined as an agreement settling a lawsuit in which the defendant or one of its insurance companies pays part or all of the settlement in the form of periodic payments over a period of years or the plaintiff’s lifetime. This approach has certain tax advantages, when approved by the court and the affected parties or when created in accordance with Section 104(a)(2) or Section 130 of the Internal Revenue Code, as amended. First, if structured correctly, the periodic payment settlement will not be subject to any immediate taxation; rather, the taxes are deferred on the installments that are received until the installments are actually received. In addition, any interest, acquired by the plaintiff as a result of the deferred payments, will not be subject to taxation. In fact, plaintiffs can expect interest rates of 10% or even higher as the parties are able to negotiate such rates, based on current inflation rates, since the annuities are backed by statutory reserves and are considered safe investments.
Even tax-free interest may not be enough motivation for plaintiffs to settle their cases, but the truth is, the time value of money is considered a more significant factor than tax consequences in calculating a settlement value. Another, and likely better, option to minimize tax liability on plaintiffs is to consider entering into an Income Tax Indemnity and Escrow Agreement. Under this arrangement , settlement payments are broken down into 3 components, also known as the Veldhuis formula: damages for physical injury; compensatory damages for non-physical injury; and the taxable portion of any punitive damages. After the Veldhuis formula is used to segregate the settlement into the 3 different settlement components, typically, the physical injury proceeds portion is then deposited by the defendant into a qualified settlement fund (QSF) for the time period specified in the Indemnity and Escrow Agreement. This allotment of time must be reasonable under the circumstances, and must not exceed a period of 5 years from the date the employer established the QSF. The QSF funds are to be used to pay "qualified payments," which are the plaintiff’s reasonable and necessary expenses related to securing medical treatment, and which generally include any medical, dental, or legal expenses that plaintiff incurs in connection with a lawsuit. At the end of the time period, the QSF funds will be distributed to the plaintiff. Unlike QSFs, which are taxed as corporations for tax purposes, the Income Tax Indemnity and Escrow Agreement is structured to be disregarded and treated as a "grantor trust" (also called "section 671 trust") so that 100% of the income generated is taxed to the plaintiff in his/her individual capacity, as a grantor of the trust.
A good strategy for either of the preceding options is to consult with a tax professional in determining the best choice(s) based on individual circumstances.

Ramifications for Not Reporting The Income from a Settlement

The Internal Revenue Service (IRS) takes the taxation of lawsuit settlements very seriously, and omitting this income can be a big mistake. Failure to report compensation received in a lawsuit settlement could lead to significant penalties, as well as possible criminal charges.
Some taxpayers mistakenly believe that returning all or part of a lawsuit settlement amount to gain the tax-free return of a previous investment will forego any IRS liability. However, this tactic does not work with the IRS, and a refund of a specific portion of a settlement payment is clearly considered income, subject to appropriate taxation. No attempt should be made to avoid paying taxes on settlement income by returning some or all of the amount received.
Most taxpayers work hard to fulfill their obligation to pay the required amount of tax when it comes due. Many go out of their way to report income accurately and pay taxes on time just to avoid penalties and interest charges. All taxpayers should be advised that the Type A penalty, which is imposed by the IRS upon determining that tax was omitted due to a taxpayer’s negligence, makes no exceptions for failure to report lawsuit settlement income. The standard penalty under Type A is 20%, but the amount can be increased depending on the amount of tax that is owed.
Specifics about how and where to report lawsuit settlement income can be found at federal and state IRS sites. The Internal Revenue Code mandates the reporting requirements that a taxpayer must meet when a settlement payment received exceeds $600. This information includes what reporting forms need to be completed (usually Form 1099-MISC), and indicates how these forms are to be processed and returned to the IRS within a reporting period of 30 days of issuance. Timely filing of forms is very important, as failing to file these documents by the deadline sets the clock in motion by which any penalty will increase in severity.
Taxpayers should remember that the IRS has full access to any and all information pertinent to their tax assessment. Since lawsuit settlements are frequently publicly funded, relevant information regarding these agreements are reported in a public forum and, therefore, easily accessed by the IRS. Any income that is not reported to the IRS is eventually recovered directly from the taxpayer by the IRS through their examination of tax forms and financial records, or, indirectly through third-party sources. This information must be accurate and complete for a settlement agreement to stand up during a tax audit.

Common Questions Regarding Lawsuit Settlement Taxes

Will a lawsuit settlement change my tax bracket? Almost never. Even large settlement payouts are unlikely to increase your tax bracket significantly. Income increases for the purposes of calculating taxation on different brackets are based on annual income, not on the amount of a single settlement. Your lawyer will be able to advise you on the specifics of your likely tax implications.
Do I pay taxes on my attorney’s fees and costs? In most instances, attorney’s fees and costs are subject to taxation. However, there are frequent exceptions when the entire settlement is exempt from taxation, such as an SSI or SSDI settlement, which is generally subject to a waiting period and is owed only after a certain time period has passed.
I was sued and the other party agreed to drop all investigations if I paid them $5,000. Do I owe taxes on this settlement? Yes. According to IRS rules , fees you pay someone else in exchange for dropping a lawsuit are considered "damages" that you may be taxed on.
My husband received a medical malpractice settlement after he was hit by a car while crossing the street. He later passed away as a result of the accident. I received the settlement. Do I need to pay taxes on it? In most cases, wrongful death settlements are not subject to taxation. That said, your estate may be required to pay taxes on any interest that accrued on that settlement in an interest accumulating bank account or on a annuity policy that you may have purchased with some of that settlement.
Do I pay taxes even if I don’t receive the full settlement amount? Yes. Settlements are cases do not include fees and costs when being determined. In other words, the entire settlement amount is taxable, even if you do not receive the full amount.