Tax protocol is complex and unclear surrounding lawsuit settlement funds. Payments received from legal proceedings are usually taxable, and funds used in the legal process (such as attorney fees) are often not deductible. This varies on a case-by-case basis and can have a huge impact on your tax return. Whether awarded money is taxable or not is determined by a large variety of factors including the wording of the settlement, what the case was about, how the check and Form 1099 are prepared, and more.
One big determining factor in the IRS’s decision to tax settlement money is whether the plaintiff is suing for an injury or “physical illness” or something else. This can be a grey area, since some emotional disturbances that employees can sue for, such as PTSD, also have physical symptoms. While compensatory damages from personal physical injuries like slip and falls are not usually taxable due to Section 104 of the tax code, physical symptoms that result from emotional damages may be, depending on the wording of the complaint.
The taxable status of legal fees is also an extremely important aspect to consider while going through the litigation process. Due to a 2018 change in tax law, in many cases, attorney fees are not tax deductible. This means that if you are awarded settlement money in the amount of $100,000 but pay legal fees of $30,000, you will be taxed on the full $100,000 via W2 or 1099. Again, if your case is considered nontaxable, such as a personal injury lawsuit, taxes will not apply and this will not be an issue. If an employee sues an employer for unlawful discrimination, they will be able to deduct their legal fees. In many other cases, the law is unclear. Pre- and post-judgement income is always taxable.
What to Do to Avoid the Taxable “Grey Area” on Settlement Money
To avoid this conundrum, you have a few options. According to Forbes, it can often be beneficial to settle for less money in order to avoid prolonged legal proceedings. If you do end up engaged in a full-blown lawsuit, you should reach an agreement with the other party regarding tax issues and reporting. This agreement is not legally binding, but since the IRS follows what the plaintiff and defendant say in an audit, wording is key.
While legal proceedings can be overwhelming and it may be tempting to ignore the tax ramifications in the pursuit of winning your case, failing to do so can be a big mistake when tax season rolls around. If you are unsure where your lawsuit falls within the IRS’s rules, consult both your legal team and your tax professional to learn more about your options.
