Congratulations, you won the case and paid off your lawyer. Like most folks, you think the rest of the settlement is yours to keep. For many types of settlements, you may still owe taxes and only “net” as little as 9 cents on the dollar. That’s right; while your net may be more, we have seen net settlements as low as 9 cents on the dollar after both the taxes and attorney fees are paid. So, by example: for a $100,000 settlement, the “net – take home settlement” proceeds would be only $9,000.
Worst of all, many people only realize the existence of the huge tax bite is when tax season rolls around. Sadly, this is often after all – or a good chunk – of the settlement money has already been spent or committed.
To help you avoid such an unpleasant tax surprises, we outline ways to lower or even eliminate paying taxes on a settlement from a lawsuit.
So let’s ask How To Avoid Paying Taxes On A Lawsuit Settlement.
Key Factors Impacting Taxation of Lawsuit Settlements
Section 61 of the Internal Revenue Code stipulates that all payments received from any source are generally considered income unless an exemption exists. Determining whether your settlement award is taxable can be tricky without delving into the specifics.
The following are the common factors that determine tax liability.
· Settlements Resulting From a Bodily Injury or Illness: Injuries or illnesses with clear evidence of bodily harm are typically not taxable according to IRS regulations.
· Emotional Distress Could Have Tax Implications: It may be necessary to pay taxes on compensation for distress unless it stems from a bodily injury or illness resulting from an accident.
· Medical Expenses Compensation: Medical expenses are not subject to taxation if you did not claim deductions for related medical bills on your prior tax return. If you did claim medical deductions, you may need to pay taxes on that amount according to the IRS “tax benefit rule.”
· Taxation of Punitive Damages: Awards for punitive damages awarded against defendants are taxable. These damages can result in payouts for the plaintiff.
· Tax Treatment of Contingency Fees: Contingency legal fees do not reduce taxable income in cases where settlements are taxable. Exceptions include enforceable discrimination cases, accident and personal injury cases such as slip and fall accidents, or workers’ compensation claims. However, you will be liable for taxes on the Contingency Fee amount even if the defendant pays your attorney directly.
· Determining 1099 Income Before Finalizing Settlement: It is advisable to know whether the defendant will issue a Form 1099 and for what amount before signing the settlement agreement. If a settlement is to have the 1099 income amount, then construct the original pleadings to minimize the taxable portion.
· Capital Gains Income: Depending on the specifics of your case, you might be able to classify a portion of your settlement as capital gains income. For example, if you’re seeking damages for property damage or business-related issues, you could potentially treat the settlement as capital gains. Alternatively, your settlement may qualify as a recovery of tax basis and is, thus, not considered income.
Plaintiff Recovery Trust
A widely known tax reduction strategy is the Plaintiff Recovery Trust (PRT). As a specially designed trust, the PRT provides the benefit of reducing the tax burden related to attorney fees on taxable cases. By doing so, the PRT increases the net settlement you keep by as much as 150%.
In Summary
When you receive a settlement, multiple factors related to both the proceedings and state laws can impact whether or not taxes are payable on that amount.
It’s always a good idea to consult a tax expert to determine which regulations are relevant to your circumstances. When you talk to these professionals, such as the Plaintiff Recovery Trust experts, they can advise you on options to minimize taxes on a lawsuit settlement, and to retain more for yourself.
