Forbes has published an article, “How IRS Taxes Lawsuit Settlements”, which discusses tax planning in preparation for a settlement, especially as litigation settlement taxes have increased since 2018 . The article begins as follows:
Many plaintiffs win or settle a lawsuit only to be surprised that they have to pay taxes. Some don’t realize it until tax time the following year when IRS Forms 1099 arrive in the mail. A little tax planning, especially before you settle, can go a long way. It’s even more important now with higher taxes on litigation settlements since 2018. Some plaintiffs are taxed on their attorney fees too, even if their lawyer takes 40% off the top. In a $100,000 case, that means paying tax on $100,000, even if $40,000 goes to the lawyer. The law generally does not impact physical injury cases with no punitive damages. It also should not impact plaintiffs suing their employers, although there are new wrinkles in sexual harassment cases. Fortunately, there are often ways to deduct legal fees even under the new law.
Taxes depend on the “origin of the claim.” Taxes are based on the origin of your claim. 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 condo 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 condo. The rules are full of exceptions and nuances, so be careful, how settlement awards are taxed, especially post-tax reform.
Recoveries for physical injuries and physical sickness are tax-free, but symptoms of emotional distress are not physical. If you sue for physical injuries, damages are tax-free. Before 1996, all “personal” damages were tax-free, so emotional distress and defamation produced tax-free recoveries. But since 1996, your injury must be “physical.” 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. The rules can make some tax cases chicken or egg, with many judgment calls. If in an employment dispute you receive $50,000 extra because your employer gave you an ulcer, is an ulcer physical, or merely a symptom of emotional distress? Many plaintiffs take aggressive positions on their tax returns, but that can be a losing battle if the defendant issues an IRS Form 1099 for the entire settlement. Haggling over tax details before you sign and settle is best.
Click here to see the full article: “How IRS taxes Lawsuit Settlements”
Posted by Marin Larkin, Associate Editor, Wealth Strategies Journal.