Lawsuit Taxability – Get The Best Tax Results When Settling A Lawsuit
Under current tax rules, its possible for lawsuit winners to owe nearly as much tax as the statement amounts they receive. Strategy: Before you accept any court-awarded monetary damages, check whether you can draft the settlement in a way that minimizes taxes.
Key Point: Settlements shouldn’t be drafted so the award to the prevailing party is described as a lump sum. Significant portions of an award may not be taxable but the opportunity to save on taxes is often lost when the settlement is an all-inclusive amount.
It’s important to determine the tax consequences of a settlement before it is signed. Once your name is on the dotted line, you’re stuck.
Here are some tips that can save thousands of tax dollars:
- Court-awarded reimbursements for medical expenses and personal injuries aren’t taxable. In contrast, punitive damages are taxable as ordinary income. Damage awards for nonphysical injuries, such as age discrimination or injury to your reputation, are also taxable.
- If, possible settlements should be drafted to describe part of the monetary award as compensation for medical expenses or personal injury so that a portion can escape taxation.
- If the same settlement is drafted as a lump sum, including punitive damages and interest, the entire award is likely to be taxed. The difference in taxes could be huge.
- You can deduct attorney fees in a court settlement as miscellaneous itemized deductions on Schedule A. These deductions are limited to the amount exceeding 2 percent of your adjusted gross income. However, miscellaneous deductions are phased out for high-income taxpayers and deductions for attorney’s fees aren’t allowed when calculating the alternative minimum tax.
- It’s customary for a settlement to be reported to the recipient with a 1099-MISC form sent for the entire amount.
Better approach: Request that the award be split, with one payment going to you and a separate payment going to the attorney. Make sure your contingent fee contract with your attorney reads the same way.
