If you’ve been involved in a lawsuit or settlement and have been awarded a sum of money, you might think that money is yours to spend, free and clear. You’ve paid back the entitled parties, your lawyer got his or her cut, and now you’re ready to buy yourself something nice!
Unfortunately, the IRS is also waiting for their portion of your settlement. You might not even realize that you owe taxes on your lawsuit settlement until you receive a 1099 at tax time. Depending on the type of lawsuit and the types of damages awarded, a portion or potentially all of your settlement funds could be taxed as income.
If you’ve been awarded funds from a legal settlement, it would be smart to use a portion of that money to pay an experienced accountant for tax preparation services to make sure that your settlement is taxed correctly. Your accountant can make sure that your tax return is properly prepared; and if you are unable to pay your tax bill, they can help you with payment options.
The general rule is that lawsuit settlements are taxable, except in cases that involve an actual, physical injury (“observable bodily harm”) or illness that you suffered. In other words: personal injury settlements usually aren’t taxable, while other types of settlements usually are.
However, the settlement agreement can award money for different types of damages, so it is possible to owe taxes on a portion of the full amount.
The following categories of settlement proceeds are typically not taxable:
The following categories of settlement proceeds are typically taxable:
Taxes on settlements are often not clear cut. Your personal injury settlement may involve some punitive damages, settlement interest, or compensation for medical expenses that you already claimed deductions for in a prior tax year. If this is the case, you may owe taxes on a small portion of your physical injury settlement payments.
Conversely, you may have been the plaintiff in a wrongful termination lawsuit, and the emotional distress of the wrongful termination may have caused you physical sickness. Your doctor’s bill for the resulting migraines may be part of the settlement payment, and that portion would not be taxable. However, emotional distress damages that do not involve physical symptoms are still taxable.
Most settlement proceeds get the same tax treatment as ordinary income. You should receive a 1099-MISC from the insurance company that paid the settlement and should add that to your tax return in the appropriate box. Lost wages may result in a W-2 tax form for reporting purposes. You may also receive a 1099-INT if you received judgment interest.
If you use tax software to file your tax return, it should prompt you on how to enter these amounts. However, taxes can be complicated, and the benefits of a tax accountant are numerous. If you have any questions, or if you think there are errors on the tax forms you received following a lawsuit settlement, the help of a tax lawyer can be invaluable.
There are ways to avoid paying taxes if the lawsuit is still ongoing. A little tax planning can save you money, even on personal injury cases. For instance, if you have a large taxable amount, like punitive damages, you might be able to get that money reallocated to a tax-free amount like personal physical injuries.
In addition, whether you accept a lump sum payment versus monthly settlement payments can make a big difference in what taxes you will owe. A large windfall can put you into a higher tax bracket. A common misconception is that this will increase the taxes on all your regular income as well, but in reality, you only pay a higher percentage on any amount that is above the tax bracket threshold. An experienced accountant can give you tax advice to help you with settlement negotiations for tax purposes.
RELATED: Determining Income Type, Differences With Earned & Unearned Income
If you hire a contingent fee lawyer, and you are awarded taxable damages, you may be surprised by your tax bill. The contingent fee cut is often taken out of your settlement money before you receive it, but you should expect to be taxed on the entire amount.
This may result in higher taxes than you expected, because you may have expected to only owe taxes on the amount you received. This can be very stressful, especially if you do not realize it until tax time the following year.
Tax planning is essential if you receive funds from legal settlements.
RELATED: The Benefits of Year-Round Tax Planning and Organization
If you are in the middle of a legal settlement, or if you have recently received settlement damages, it’s important to start your tax planning now. If your funds are coming from personal injury settlements, you may still want to have a tax attorney look over the settlement to make sure all the damages are tax free.
Our team is very familiar with how lawsuit settlements are taxed and will give you our honest advice about how to approach your annual tax return. We can set up a free consultation to learn more about your settlement, just give us a call at (410) 872-8376 or fill out this online form and we can take a look at the details of your case.
The content provided here is for informational purposes only and should not be construed as legal advice on any subject.
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