5 Rules on Taxation of Lawsuit Settlements

Posted January 29, 2020

THE TRUMP TAX REFORM LAW changed the taxation of lawsuit settlements and judgments in several important ways. Here are five rules to know.

1. Taxes on a Lawsuit Settlement or Judgment Depend on the Origins of the Claim. If the lawsuit seeks recovery of amounts that would be subject to taxation, then the settlement is taxable. For example, if you get laid off at work and sue seeking wages, you’ll be taxed as wages, and probably some pay on a Form 1099 for emotional distress. But if you sue for damage to your house by a negligent building contractor, your damages may not be income. You may be able to treat the recovery as a reduction in your purchase price of the house. The rules are full of exceptions and nuances, so be careful, and be sure to consult a qualified attorney or other tax professional.

2. Settlements or Awards for Physical Injuries Are Tax-Free. Emotional distress damages are taxed unless they stem from physical injuries. If you sue for physical injuries, damages are tax-free.  That includes damages for emotional distress arising out of the physical injuries.  But if you sue for intentional infliction of emotional distress, your recovery is taxed. Physical symptoms of emotional distress (like headaches and stomachaches) is taxed, but physical injuries or sickness is not. Applying the rules to specific cases can be a chicken and egg type exercise, with difficult judgment calls. For example, if in a discrimination lawsuit you receive $50,000 extra because your employer gave you an ulcer, is an ulcer physical, or merely a symptom of emotional distress? A plaintiff can take an aggressive position on their tax return, but that can be a losing battle if the defendant issues an IRS Form 1099 for the entire settlement. The best practice is to negotiate the tax details before you sign the settlement agreement.  Also, if you claim a medical expense deduction for costs later reimbursed by an award or settlement, you must “recapture” the amount you’ve previously deducted on your tax return.

3. Allocating Damages Can Save Taxes.  Most legal disputes involve multiple issues. In an auto personal injury lawsuit, you might claim that the defendant-driver who rear-ended you caused you to not only to suffer injuries and incur medical expenses, but also caused you to lose three months’ wages, damaged the laptop you had in your trunk, and miss planned vacations with your family. In a construction defect claim, you might claim the contractor who installed leaky windows in your restaurant caused you to not only incur expenses to fix the leaks, but also led you to shut down your restaurant, resulting in a loss of income and damage to your business’ reputation. It is best for plaintiff and defendant to agree on tax treatment. Such agreements aren’t binding on the IRS or the courts in later tax disputes, but they are usually not ignored by the IRS.

4. Attorney Fees Can Be A Tax Trap. If you are the plaintiff and use a contingent fee lawyer, and your case is fully nontaxable (say an auto accident in which you’re injured), that shouldn’t cause any tax problems. But if your recovery is taxable, watch out! You’ll usually be treated (for tax purposes) as receiving 100% of the money recovered by you and your attorney, even if the defendant pays your lawyer directly his contingent fee cut. Say you settle a suit for intentional infliction of emotional distress against your neighbor for $100,000, and your lawyer keeps $40,000. You might think you’d have $60,000 of income. Instead, you’ll have $100,000 of income. How about deducting the legal fees? In the big tax bill passed at the end of 2017, there’s no deduction for legal fees. Tax advice early, before the case settles and the settlement agreement is signed, is essential.

5. Punitive Damages And Interest Are Always Taxable. If you are injured in a car crash and get $100,000 in compensatory damages and $200,000 in punitive damages, the former is tax-free. The $200,000 is fully taxable, and you can have trouble deducting your attorney fees. The same occurs with interest. You might receive a tax-free settlement or judgment, but pre-judgment or post-judgment interest is always taxable. That can make it attractive to settle your case rather than have it go to judgment.
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Christopher Shenfield, Attorney at Law  I handle personal injury, civil litigation, and tax matters across California and the U.S. (www.shenfieldlaw.com), addressing personal injury claims, real estate and construction litigation, business litigation, tax disputes, tax advice on legal settlements, and many other matters. You can reach me by email at chris@shenfieldlaw.com and by going to my website by clicking here.