How Lawsuit Settlements Are Taxed

Paying taxes for plaintiffs win or lawsuit settlements can be a little surprising for some people. Reality hits when tax season comes and the IRS Forms 1099 arrives in the mail. This is why before you settle, a little tax planning is highly recommended. The recently passed tax reform laws make it even more important now because of the new higher taxes on lawsuit settlements. Even if their lawyer takes 40% off the top, attorney fees are also taxed on many plaintiffs. Generally, physical injury cases with no punitive damages aren’t impacted by the new law. Although there are new wrinkles in sexual harassment cases, it also should not impact plaintiffs suing their employers. 

Here are the five rules on how lawsuit settlements are taxed:

1. “Origin of the claim” is the bases of taxes. You’ll be taxed as wages and probably some pay on a Form 1099 for emotional distress if you get let laid off at work and sue seeking wages. However, if you’re suiting a negligent building contractor for the damage to your condo, your damages may not be income. The recovery may have to be treated as a reduction in your condo’s purchase price. You need to be careful with how settlement awards are taxed because the rules are full of exceptions and nuances especially post-tax reform.

2. Physical Injuries and Physical Sickness are tax-free while emotional distress symptoms are not physical. The damages for suing for physical injuries are tax-free. All “personal” damages were tax-free before 1996. This is why emotional distress and defamation produced tax-free recoveries. But this changed since 1996 as it required that your injury must be “physical.” Your recovery is taxed if you sue for intentional infliction of emotional distress. As you can see by now, the rules can make some tax cases chicken or egg and it includes many judgment calls. For example, if an employment dispute you receive $50,000 extra because you were given an ulcer by your employer, how do would you know if an ulcer is physical or merely a symptom of emotional distress? 

3. You can save taxes by allocating damages. There are multiple issues that are sometimes involved in legal disputes. There are cases where a person claims that the defendant kept his laptop, frittered away his trust fun, or underpaid him. There’s a good chance the total settlement involves several types of consideration regardless if your dispute relates to one course of conduct. Agreeing on tax treatment is the best path to take for the plaintiff and defendant. Although such agreements aren’t binding on the IRS of the courts in later tax disputes, the IRS usually wouldn’t ignore them.

4. Attorney fees are a tax trap. For tax purposes, you’ll be typically treated as receiving 100% of the money recovered by you and your attorney if you are the plaintiff and use a contingent fee lawyer. This happens even if the defendant pays your lawyer directly his contingent fee cut. There shouldn’t be any tax problems if your case if full non-taxable but you do need to watch out if your recovery is taxable. The U.S Supreme Court held in Commissioner v. Banks in 2005 had plaintiffs to generally have income equal to 100% of their recoveries even if a share is already given to their lawyers.

You’re probably wondering about the legal fees. The Congress in 2004 enacted an above the line deduction for legal fees in employment claims and on some whistle-blower claims. Outside these two areas, there’s a big trouble although that deduction still remains. There’s a new tax on litigations settlements in the big tax bill passed at the end of 2017 - no deduction for legal fees. 

5. There are always taxes on punitive damages and interest. If you get $50,000 in compensatory damages and $5 million in punitive damages after being injured from a car crash, the compensatory damages are tax-free. You will have to pay taxes for the $5 million and deduction your attorney fees can get really painful. The same thing applies to interest. A tax-free settlement or judgment may be given to you but pre-judgment or post-judgment interest is always taxable. This means rather than have it go to judgment that can make it attractive to settle your case.