How Is Your Legal Settlement Income Taxed?

Author : Camputaro & Associates
Mar 01, 2021

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If you’re pursuing compensation in a lawsuit, or you received a settlement sometime last year, you may be surprised to learn that any settlement amount you receive in a lawsuit is taxable income. Unfortunately, very few people pursuing legal compensation for injury or other suffering look into tax planning during their legal proceedings, and they end up blindsided by a large tax bill when they file their return for the previous year. If you’re filing a return that includes income from a legal settlement, or you’re wondering how a current legal case might impact your taxes next tax season, here are a few things you need to know.

Attorney Fees Are Taxed Too

Perhaps the biggest shock to many taxpayers is discovering that they are taxed for any contingency fees paid to their attorney. Many plaintiffs think that if the defendant pays the lawyer’s contingency fee directly to the lawyer, they will not be taxed on that portion of the settlement. However, for tax purposes, you are usually treated as having received 100% of the money paid out in the case.

This means that if you receive a $100,000 settlement, and your lawyer receives a 40% contingency fee, you’ll only actually receive $60,000 in the settlement. However, you’ll still have to pay your appropriate tax rate on the full $100,000 settlement amount. It’s important to be prepared for this and keep taxes in mind when negotiating your settlement.

Attorney Fees Aren’t Usually Deductible

Now, you might be thinking, “I’ll at least be able to deduct those attorney fees from my taxable income for the year, right?” Unfortunately, the answer to that is most likely a no. Certain whistleblower claims and employment cases do allow for attorney fees to be deducted. If your case falls into this category, we can help you to determine if those fees will be deductible for you.

However, if your settlement is from any other kind of case, your attorney fees can’t be deducted from your annual income. This is an unpleasant surprise for many so, once again, be prepared for this and keep it in mind during negotiations.

Not All Settlements Are Taxed

Before you get too worried about the taxes on your settlement amount, it’s important to note that not all money paid out in court is considered taxable. Damages paid for physical injuries are not taxable; however, emotional suffering and other non-physical forms of injury are taxed. So, if you are injured in a car accident, and you receive payment for your physical injuries, damage to your property, and your emotional pain and suffering, the amount awarded for the latter category is the only part of your settlement that will be taxed.

This differentiation can cause some gray areas, since payments for physical injuries and illness are not taxable, but compensation for physical symptoms of emotional distress are. For example, let’s say that you experienced severe stress as a result of the defendant’s actions, and you end up developing an ulcer. Is that ulcer a physical symptom of your emotional distress, or an injury that you’ve suffered as the result of the defendant’s actions? Your attorney could argue this either way, but it’s important to be aware of the tax implications when making those arguments, so that you can try to have that portion of the settlement remain untaxed.

Punitive Damages Are Always Taxed

While the above types of compensation can have blurred lines, punitive damages are much more cut-and-dry. Any punitive damages awarded in a legal case will be taxed at your normal tax rate. So, if you’re seeking a large amount in punitive damages against the defendant, be prepared to pay a large amount in tax as well.

How Settlement Amounts Are Taxed

Now that you have a better understanding of what is and is not taxed, you might be wondering exactly how the amount you receive is taxed. Is it taxed as wages? Is it taxed like winnings from the lottery or gambling?

The way your settlement is taxed depends on the origin of your claim—essentially, the kind of claim you’re making. If you’re suing for wrongful termination and are awarded the wages you should have received, the settlement will be taxed as wages (and perhaps some additional amount for emotional distress on a Form 1099). If you’re suing for property damage, you could treat the settlement as a reduction in your condo’s purchase price.

There are a great deal of rules, exceptions, and nuances involved with taxation on legal settlements, so it’s essential that you consult with an accountant to understand how to best handle the amount you receive on your tax forms. Better yet, speak to one of our CPAs during your settlement negotiations so that you can negotiate an amount that will be fair to you even after taxes have been applied. Give us a call to schedule an appointment today.

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Camputaro and Associates
Certified Public Accounting Firm
136 N. Orchard Street, Suite 8
Ormond Beach, FL 32174
(386) 255-2511