If you are the plaintiff in a lawsuit and receive a settlement offer, it may be helpful to consider the tax implications of accepting it. What follows is a general overview of the area.
The first rule to remember is that, from the IRS’ perspective, all income is taxable unless it is exempted by the Internal Revenue Code. This means the plaintiff should expect to pay taxes on the settlement.
The tax treatment will depend on many factors, but especially on the type of legal claims and damages involved. Generally speaking, a payment to the plaintiff to compensate for physical injuries or sickness is not taxable. On the other hand, monies which the plaintiff receives for lost profits, injury to professional reputation, or injury to other economic interests are generally taxable. One exception is when the plaintiff simply receives a return of monies he or she previously paid to the defendant, such as the return of a premium or deposit. This type of “restitution” is usually not taxable. On the other hand, if interest were paid along with the returned funds, the interest would be taxable.
Payments for property damages are a bit more complicated. The starting point is the owner’s basis in the property. If the payments received for the property damage are greater than the owner’s basis in the property, the excess is treated as a gain and may be taxable depending on such factors as whether the property was completely destroyed and was the owner’s primary residence. Even if there is a gain, in some cases, the owner may be able to defer reporting by using the excess amount to purchase a replacement residence within a specified period of time. In addition, if the owner does not spend all of the monies received on repairing the property, then there may also be a gain. It is essential to consult with a tax advisor in connection with property damages which can be complicated.
Other types of damages include payments for attorney fees, which are often taxable. The portion of the settlement designated for a contingency lawyer’s fees will count as the plaintiff’s income ordinarily. For example, if the defendant gives a settlement check of $100,000, and $50,000 is for attorney fees, and $50,000 is for taxable damages, the plaintiff is generally treated as receiving the entire $100,000 for tax purposes.
Payments for punitive damages are also taxable. This is true regardless of whether the underlying injury was physical or purely an economic loss.
Interest is taxable whether it is pre-judgment or post-judgment interest.
Often parties try to avoid taxation by creatively naming the settlement payments one way or another. The IRS will scrutinize the Complaint and Settlement Agreement in any audit. For example, in a case where the plaintiff asserts a minor physical injury and major economic losses, if the settlement agreement provides for a large payout for the physical loss, and only a small amount for the economic loss, this could trigger examination by the IRS – and lead to a reallocation of the settlement to reflect the actual facts and circumstances, along with penalties.
Finally, there are reporting obligations. The defendant will usually report the payments to the IRS and will do so using Form 1099-MISC or, in the case of wages, using Form W-2.
By Priya Bhatt
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