The taxation of legal settlements and fees is a complex topic. While the mechanics to make a proper claim are now easier, the rules are still complex. Below we look at six rules to consider when it comes to the taxation of legal settlements and the deduction of legal fees on your taxes.
- Taxes depend on the origin of the claim; or in plain English, according to why you are seeking recovery. For example, in a case where the plaintiff is suing another business for losing profits, the settlement would be considered lost profits and therefore would be ordinary business income. If a worker sues for unlawful termination, then the settlement would be considered wages and taxed accordingly. Another example is where a plaintiff sues a negligent builder; here the damages won’t be classified as income but instead will reduce the purchase price of the real estate.
The big difference in the above examples is that in the first two cases the settlements are taxable; in the third, they are not. As with many things in tax law, be aware that the rules are full of nuance and exceptions.
- Some recoveries are tax-free, even if they wouldn’t appear to be on the surface. One example here is cases of personal physical injuries, like a car accident. While you may be suing for lost wages due to the inability to work, the damages should be tax-free due to section 104 of the tax code that shields damages for personal physical injuries and physical sickness.
The important distinction here is the physical requirement. The IRS is unclear exactly what constitutes physical harm but generally requires that you can physically see the injury.
- Medical expenses are tax-free. Regardless of the type of harm (physical or emotional), payments for medical expenses are tax-free. Moreover, the definition of medical expenses is rather broad.
- Allocating damages can save on taxes. Most legal disputes involve multiple issues, and as a result, the total settlement amount will involve several types of considerations. The parties in suit can agree to the allocation of the settlement according to the issues – and therefore its tax treatment. While these agreements aren’t binding to the IRS, they’re rarely ignored and can provide a good defense for your tax position.
- Attorney fees can be a trap. However, you pay your attorney – whether hourly or on a contingent fee basis – legal fees will affect your net recovery and your taxes. Plaintiffs who use contingency fee arrangements are typically treated (for tax purposes) as receiving 100 percent of the money recovered. In other words, you’re taxed on the part of the money your attorney takes out of the settlement.
To understand this a little better, take an example suit for emotional distress where you recover $200,000 in damages, with a 40 percent contingency fee arrangement with your attorney. Here, the plaintiff is going to have $200,000 in taxable income even though they only received $120,000 (with $80,000 going to the attorney). Not all lawyers’ fees face this draconian tax treatment, but this is the general rule in contingency fee cases.
- Punitive damages and interest are always taxable. This is true even if the injuries are 100 percent physical. Take a case of a car crash where you get $30,000 in compensatory damages (for the car damage) and $2 million in punitive damages. The $30,000 is tax-free, but the $2 million is fully taxable.
These are some of the basic rules surrounding the taxation of legal fees and settlements. There are many nuances and subtleties, but what you should take away from this article is that, in many cases, there are ways to structure both any settlement received and how you pay your attorney to minimize your tax burden.