What Legal Settlements Are Taxable and How to Minimize Taxation of Settlement Awards

Receiving a settlement from a lawsuit can provide much-needed financial relief, but it can also raise important questions about the taxability of those funds. Understanding the tax implications of lawsuit settlements is crucial for individuals seeking to maximize compensation, minimize the associated tax impact, and avoid potential pitfalls with the Internal Revenue Service (IRS).

In this analysis, we focus on:

• Are settlement payments taxable income,
• How to avoid paying taxes on a lawsuit settlement, and
• The confusing and complex world of lawsuit settlements and awards taxation, explore when an award or settlement is taxable, discuss strategies to minimize tax liability, analyze the distinction between physical injury and non-physical injury claims, and highlight the critical role of settlement agreements, Qualified Settlement Funds (QSFs), and Plaintiff Recovery Trusts in minimizing the tax impact on lawsuit settlements and awards.

Understanding the Taxability of Lawsuit Settlements

Generally, the primary law regarding the taxability of amounts received from lawsuit awards and settlements is Section 61 of the Internal Revenue Code (IRC).

Specifically, this code section states that “gross income means all income from whatever source derived…” unless another code section exempts the income source.¹ Section 104 of the IRC excludes taxable income settlements and awards due to lawsuits stemming from physical injuries.² However, the relevant IRS guidance states that one should consider “the facts and circumstances surrounding each settlement payment” to determine the settlement proceeds’ purpose accurately, as “not all amounts received from a judicial award or settlement are exempt from taxes.”³

Types of Judicial Awards and Settlements

Judicial awards and settlements can be divided into groups to determine whether the associated payments are taxable or non-taxable. According to relevant IRS guidance, “the first group includes claims relating to physical injuries, and the second group is for claims relating to non-physical injuries.”⁴ Once funds have been classified into one of these two groups, a further subdivision is made, and the funds will usually fall into the following categories:

• Actual damages resulting from physical or non-physical injury
• Emotional distress damages arising from the actual physical or non-physical injury
• Punitive damages
• Compensatory Damages
• Interest on the award or settlement

Importantly, award or settlement proceeds received for personal physical injuries or sickness are excludable from the recipient’s gross income under IRC Section 104(a)(2).⁵ For emotional distress recoveries to be excludable from taxation, the underlying damages must be due to personal physical injuries or illness.

Pro Tip: Any amount which is a reimbursement of past actual medical expenses that was previously deducted is also taxable.⁶

Pro Tip: Punitive damages are never excludable from gross income (thus, they are always taxable), except for damages awarded for wrongful death in states where only punitive damages may be awarded.⁷

Strategies to Minimize Your Tax Liability on Settlement Money

There are several strategies plaintiffs can employ to minimize their tax liability on settlement money. Plaintiffs may reduce their taxable income by justifiably allocating damages to non-taxable award categories like physical injuries and medical expenses and decreasing amounts related to emotional distress.

Structured settlements offer a way to spread payments over multiple years and may keep the plaintiff in a lower tax bracket and reduce the overall tax burden compared to receiving a lump sum.

Qualified Settlement Funds (QSFs) provide short-term tax deferral and flexibility for plaintiffs to plan when and how to receive payments while allowing defendants to claim an immediate tax deduction. QSFs act as a settlement resolution tax tool, assuming tort liability from defendants. While QSFs do not directly provide long-term tax reduction benefits, they facilitate spreading settlement payments over time as ordinary income or capital gains instead of taking a large lump sum, which can significantly lower the taxes owed by keeping the plaintiff out of higher tax brackets in a given tax year. A QSF should be strongly considered for every settlement, as they facilitate lien resolution and other post-settlement issues and disputes.

Legal Insights and Professional Tax Advice

Navigating the complex tax implications of lawsuit settlements requires guidance from subject matter experts and experienced tax professionals. Consulting with an experienced settlement tax expert before finalizing a settlement agreement or even before filing the case can provide valuable insights into the potential tax consequences and help plaintiffs negotiate more favorable tax outcomes.

If justified, allocating damages to non-taxable categories like physical injuries and medical expenses may be helpful. However, avoid unwarranted attempts to negotiate the amount reported on Form 1099, as adverse tax consequences may arise from such tactics.

Pro Tip: Be aware that above-the-line income deductions for attorney fees typically raise IRS audit flags, and the IRS, as their examination guidelines call for, will apply scrutiny to the elements of the original pleadings, which is often known as the origin-of-the-claim test. The IRS can use the original pleadings against the taxpayer to disallow exemption classification. The origin-of-the-claim test (not the 1099 issued) will determine the nature of legal fees, thereby deciding how the attorney fees are treated for tax purposes. It is essential to examine the facts of the pleaded claim(s) and ask why the individual hired an attorney – for example, was it to enforce a civil right violation or enforce some other claim(s)? Answering these questions should enable the determination of whether the fees are nondeductible personal expenses, business or income-related, or capitalizable as related to a property interest. As much as some advisors will lead you to believe otherwise, if not justified, there are severe potential adverse consequences for classifying the attorney’s fee portion in this manner.

Commissioner v. Banks

In Commissioner v. Banks, 543 U.S. 426 (2005), the United States Supreme Court addressed the question of the plaintiff’s taxation of the portion of a judgment or settlement paid to a taxpayer’s attorney under a contingent-fee agreement.

There, the Court held that the total (taxable) settlement proceeds, including the contingent attorney fee portion, are income attributable to the plaintiff-taxpayer for federal income tax purposes. As such, attorney fees also impact a plaintiff’s tax obligations, and the Tax Cuts and Jobs Act of 2017 severely limited the deductibility of legal fees. Tools like structured settlement annuities and Plaintiff Recovery Trusts can significantly mitigate the tax burden and maximize the plaintiff’s net recovery.

It is crucial for plaintiffs, with tax implications in mind, to shield their settlements from excessive taxation by seeking professional tax advice and carefully shaping the settlement agreements.

Conclusion

Lawsuit settlements can provide much-needed financial relief, but understanding their tax implications is crucial for maximizing compensation while avoiding issues with the IRS. By recognizing the distinction between physical injury and non-physical injury settlements, utilizing settlement agreements effectively, and considering tools like Qualified Settlement Funds and the Plaintiff Recovery Trust, plaintiffs can minimize their tax liability and protect their financial interests. Seeking guidance from experienced tax professionals and attorneys is essential to navigating the maze of settlement taxation.

Proactive tax planning and carefully structured settlement agreements shield the associated proceeds from unnecessary taxation. By being informed and working closely with legal and financial experts, plaintiffs can ensure they receive the full benefits of their settlements while minimizing their tax obligations, allowing them to focus on moving forward after successfully resolving their legal claims.

FAQs

How can I minimize taxes on a lawsuit settlement?

To minimize taxes on settlement money, consider the following strategies:

• Establish a Plaintiff Recovery Trust – you must do so before the final settlement or judicial award, including appeals.
• Establish a Qualified Settlement Fund with QSF 360 to provide deferral options and time for planning.
• Maximize exclusions for medical expenses.
• Allocate, in detail, all damages in the Settlement Agreement to specify what each portion covers and stipulate the payment into a QSF.

Which types of settlements are exempt from taxes?

Settlements for physical injuries are generally not taxable. Therefore, you typically do not need to pay taxes on these types of settlement money (except for any associated punitive damages, which are always taxable).

How should I report a taxable lawsuit settlement on my tax return?

The taxable portion of a legal settlement, including those that involve previously deducted medical expenses related to physical injuries or illnesses and punitive damages, should be reported as miscellaneous (other) income on your tax return. Any interest earned on the settlement the plaintiff receives is also taxable.

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