It`s important to know the tax implications of a settlement if you are awarded one. There can be numerous nuances involved with this topic and working with an experienced attorney and accountant can help identify which portions may be tax-free and which ones require taxes to be paid on.
Taxes on a lawsuit settlement
Settlement allows both parties to reach an agreement without going to trial, saving both time and expense in doing so. Sometimes this approach results in better outcomes as it gives both sides more control of the case as well as substantial compensation payments for both.
Be aware that any settlement may be subject to tax. Doing some proactive tax planning before receiving any settlement money could significantly lower your taxable income and bring peace of mind for years after.
Tax exempt damages such as medical expenses should be discussed during settlement negotiations to avoid potential surprises in terms of taxation.
IRS also has ruled that emotional distress damages can be tax-free, such as if the actions of your employer worsens your symptoms of multiple sclerosis. A portion of any settlement may even be tax-free.
Non-economic damages
Non-economic damages provide compensation for losses that cannot be measured financially, such as lost income, physical pain and suffering, emotional distress, disfigurement or disability, as well as decreased enjoyment of life.
Most personal injury cases are settled outside of court.
Non-economic damages are calculated by multiplying a victim`s total economic damages with an appropriate multiplier, with higher multipliers applied in cases involving permanent impairment, catastrophic injuries and other significant damages.
When determining non-economic damages a jury will consider a variety of factors, such as subjective values, beliefs, emotional sensitivity, feelings of injustice, and disruptions to their lives caused by others.
Punitive damages
If your case involves a defendant who committed acts of oppression, fraud, or malice against you, punitive damages may be available as legal compensation from a judge or jury in addition to compensatory damages to make an example out of them.
Punitive damages awards usually depend on how reprehensible a defendant`s conduct was; most states limit them to no more than four times the amount awarded as compensatory damages.
Punitive damages exist to deter defendants from engaging in similar behavior in the future and maintain an equitable civil justice system by discouraging plaintiffs from demanding excessive amounts for minor events.
Attorney fees
Numerous federal laws, such as those protecting consumers from debt collection practices, employment discrimination and environmental harm, permit courts to award attorney fees to winning plaintiffs in court cases.
These awards are not deductible under current tax laws, as they are considered income to both the plaintiff and the attorney.
The new tax law undermines consumer protections in this way. It can make it more challenging for people to assert their rights, as well as deprive them of vital benefits such as Earned Income Tax Credit (EITC).
You must report the settlement as income if you are a plaintiff. If you don`t, the IRS could assess taxes on your entire settlement before deducting legal costs.