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 1099s 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 also pay taxes on their attorneys' fees, even if their attorney takes the top 40%. In a $ 100,000 case, that means paying taxes on $ 100,000, even if $ 40,000 goes to the attorney. The law generally does not affect physical injury cases without punitive damages. It also shouldn't affect 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.
The taxes depend on the "origin of the claim". Taxes are based on the origin of your claim. If you are fired at work and demand a salary, you will be taxed as wages, and some will probably pay on a Form 1099 for emotional distress. But if you file a claim for damage to your condo by a negligent construction contractor, your damages may not be income. You may be able to treat the repossession as a reduction in the purchase price of the condo. The rules are full of exceptions and nuances, so be careful how settlement awards are taxed, especially after-tax reform.
Recoveries for physical injuries and physical illnesses are tax-free, but the symptoms of emotional distress are not physical. If you file a lawsuit for physical injury, the damages are tax-free. Before 1996, all "personal" damages were tax-free, so emotional distress and defamation produced tax-free recoveries. But since 1996, his injury must be "physical." If you file a lawsuit for intentionally inflicting emotional distress, your recovery is taxable. Physical symptoms of emotional distress (such as headaches and stomachaches) are taxable, but physical injury or illness is not. The rules can turn some tax cases into chicken or egg, with many judgment calls. If you receive an additional $ 50,000 in a labor dispute because your employer gave you an ulcer, is it a physical ulcer or just 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. It is best to haggle over the tax details before signing and reaching an agreement.
It is best to agree on the tax treatment. It is better for the plaintiff and the defendant to agree on the tax treatment. Such agreements are not binding on the IRS or the courts in subsequent tax disputes, but the IRS generally does not ignore them. Most legal disputes involve multiple issues. You can allege that the defendant kept your laptop, wasted your trust fund, underpaid you, failed to reimburse you for a business trip or other items. Even if your dispute relates to a course of conduct, it is very likely that the entire agreement will involve several types of consideration.
The way that legal fees are taxed is complicated. If you are the plaintiff and use a contingent fee attorney, you will generally be treated (for tax purposes) as if you received 100% of the money recovered by you and your attorney, even if the defendant pays your attorney directly for your cut of contingent fees. If your case is totally tax-exempt (let's say a car accident in which you were injured), that shouldn't cause any tax problems. But if your recovery is taxable, be careful. Let's say you settle a lawsuit for intentionally inflicting emotional distress on your neighbor for $ 100,000 and your attorney is left with $ 40,000. You might think you would have $ 60,000 of income. Instead, you will have $ 100,000 of income. In 2005, the US Supreme Court upheld Commissioner v. Banks, that plaintiffs generally have income equal to 100% of their recoveries. even if your lawyers take a part.
How about deducting legal fees? In 2004, Congress enacted an above-the-line deduction for legal fees on employment claims and certain whistleblower claims. That deduction still remains, but outside of these two areas, there is a big problem. In the big tax law passed in late 2017, there is a new tax on litigation settlements, with no deduction for legal fees. No tax deduction for legal fees is a strange and unpleasant surprise. Early tax advice, before the case is resolved and the settlement agreement is signed, is essential.
Punitive damages and interest are always taxable. If you are injured in a car accident and collect $ 50,000 in compensatory damages and $ 5 million in punitive damages, the former is tax-free. But the $ 5 million is fully taxable and you may have trouble deducting your attorney's fees. The same goes for interest. You may receive a tax-free settlement or judgment, but pre-judgment or post-judgment interest is always taxable (and can cause problems with attorney's fees). Sometimes that can make it attractive to settle your case instead of going to trial.
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