How to Minimize Tax Liability on Lawsuit Settlements or Avoid Paying Taxes on Settlement Money

In the aftermath of winning or settling a lawsuit, it is vital to understand potential federal and state income tax implications and how to avoid paying taxes on settlement money. While some settlements may be subject to federal and state income taxes, there are strategies you can employ to abate your tax liability, such as the Plaintiff Recovery Trust. By acquainting yourself with the rules and regulations surrounding taxable settlements, you can make informed decisions and potentially reduce your tax burden. In this comprehensive guide, we review the various factors that affect the taxability of lawsuit settlements and provide actionable tips to help you navigate the complex world of taxes on settlement money.

Understanding Taxability: The General Rule

According to the Internal Revenue Code (IRC) 61, all payments from any source are considered gross income unless a specific exemption exists. This general rule applies to lawsuit settlements as well. However, IRC §104(a)(2) excludes taxable income for certain types of settlements and awards. In determining the taxability of a settlement, it is crucial to consider the purpose for which the settlement or award was received. Not all payments received from a legal settlement or award are exempt from federal and state income taxes, so analyzing the specific circumstances surrounding each settlement payment is essential.

Determining Tax-Exempt Settlements

When identifying which settlements are tax-exempt, it’s essential to understand the IRS’s audit criteria. These criteria play a material role in determining the taxability of a lawsuit settlement:

1. Physical Injury or Sickness

Settlements related to physical injuries or illnesses, where there is observable bodily harm, are generally not considered taxable by the IRS. Compensation for medical expenses, lost wages, and pain and suffering from physical injuries falls under this category. These settlements are often tax-exempt, relieving individuals who have suffered physical harm or illness.

2. Emotional Distress

While settlements for physical injuries or illnesses are tax-exempt, emotional distress awards are typically subject to taxes. However, if the emotional distress directly results from the physical injury or an illness caused by the accident, it may still qualify for tax-exempt status. However, it is essential to establish a clear association between the emotional distress and the physical injury or illness to limit the taxability of the settlement.

3. Medical Expenses

Settlements designated explicitly for medical expenses are generally not taxable. However, if you have previously deducted these medical expenses on your tax return, the corresponding settlement amount will be subject to taxes under the IRS ‘tax benefit rule.’ This rule ensures that you do not receive a double tax benefit by deducting medical expenses and excluding settlement proceeds related to those expenses.

4. Punitive Damages

Generally, punitive damages penalize the defendant for their wrongdoing. As such, punitive damages are almost always taxable; whether or not the underlying case involves physical injuries, the IRS considers punitive damages taxable income. It’s important to note that only the portion allocated to physical injuries compensatory damages may be eligible for tax-exempt status if the settlement includes physical injuries compensatory and punitive damages. Said another way, Punitive damages are ALWAYS taxable.

5. Taxation of Contingency Legal Fees

Depending on the nature of the settlement, the resulting taxation of your litigation award may include taxation of the attorney fees portion, particularly contingency-based attorney fees. If your settlement is tax-exempt, the legal fees and costs associated with the case will not affect your taxable income. However, if your settlement is taxable, you may owe taxes on the total settlement amount (including the attorney fee portion), even if the defendant pays your attorney directly. It’s crucial to consider the tax implications of legal fees when negotiating settlement agreements.

Pro Tip: Use the following link to learn more about paying taxes on the attorney fee portion of a settlement and how to avoid taxation with a Plaintiff Recovery Trust.

Strategies to Minimize Tax Liability

Having now an understanding of the factors that determine the taxability of lawsuit settlements, let’s explore some practical strategies to minimize your settlement tax liability:

1. Allocate Damages Appropriately

During settlement negotiations, you may have the opportunity to allocate a more significant portion of the settlement to non-taxable award categories, such as physical injuries or illnesses. By strategically negotiating the allocation of damages, you can potentially reduce the taxable portion of your settlement and minimize your overall tax liability.

2. Spread Payments Over Time

Receiving a sizeable taxable settlement in a single tax period (year) may push you into a higher overall tax bracket, resulting in the highest tax rate applied to the settlement. Consider negotiating for periodic payments spread over multiple years to avoid this potential tax burden. By receiving smaller payments over time, you may reduce the portion of your income subject to higher tax rates.

3. Consider Qualified Settlement Funds

Qualified Settlement Funds (QSFs), like QSF 360, provide a mechanism to defer taxes on settlement proceeds. By establishing a QSF, the settlement funds are held in a §468B statutory trust, allowing you to defer tax liability as long as unresolved liens or secondary issues remain. QSFs offer flexibility and are particularly useful for individuals with complex settlement arrangements or ongoing litigation.

Pro Tip: QSFs do not operate as long-term tax deferral vehicles.

4. Take Advantage of Capital Gains Treatment

Depending on the nature of your claim, you may be able to treat a portion of your settlement as capital gains instead of ordinary income. If your settlement involves damage to property, such as a home or business, you might qualify for capital gains treatment. Consult a tax professional to determine if this strategy applies to your situation.

5. Seek Professional Tax Advice

Navigating tax law intricacies can be challenging, especially regarding lawsuit taxation. To take advantage of all available tax-saving opportunities, it’s advisable to seek professional tax advice. A tax professional experienced explicitly in the taxation of lawsuit proceeds can guide you through the complexities of tax planning, help you understand the specific tax implications of your settlement, and assist you in optimizing your tax strategy.

6. Eliminate the Taxation of Attorney Fee Portion

As discussed in ‘Why Taxes on Lawsuit Settlements Are Higher Than You Think,’ one of the most significant tax traps for plaintiffs is your taxation of attorney fees. Suppose you are a plaintiff represented by a contingent fee lawyer. In that case, the IRS considers you to have received 100% of the money recovered, even if the defendant pays your lawyer directly. This ‘tax doctrine’ means that, in most cases, you will face taxation on the entire settlement amount – Yes, 100% of the settlement payment – even if a portion goes to your attorney.

Pro Tip: As an example of the above, if you settle a lawsuit for $100,000, and your lawyer takes $40,000 as a contingency fee, you will still face taxation on the total $100,000, which is undoubtedly an unhappy outcome.

Pro Tip: There is an effective solution for many circumstances – the Plaintiff Recovery Trust – but it must be in place before finalizing the settlement or judicial award.

‍

‍

Conclusion

Winning or settling a lawsuit is a significant achievement, but it’s crucial to understand the potential tax implications of your settlement. In many circumstances, the Plaintiff Recovery Trust may assist in minimizing the tax burden.

By acquainting yourself with the laws, regulations, and rules surrounding taxable settlements and judicial awards, you can make knowledgeable decisions to abate tax liabilities.

ProTip: Remember to consider factors such as physical injury or sickness, emotional distress, punitive damages, and contingent legal fees when assessing the taxability of your settlement.

Pro Tip: Use this link to learn when you will also have to pay taxes on the attorney fee portion of a settlement and what options are available to avoid such.

Employing strategies like the Plaintiff Recovery Trust, QSF360, allocating damages appropriately, spreading payments over time, andseeking professional tax advice can help you navigate the complexities of taxationon lawsuit settlements and awards to optimize your overall financial outcome.