When it Comes to Settlements, Make Sure You’re Not Settling for Less
Take a look at the tax rules for receipt of damages or settlement proceeds. Amounts you receive for physical injuries or physical illness are nontaxable. Compensation for emotional distress is generally taxable…with two narrow exceptions. Amounts paid for mental anguish that arises from physical injuries are tax-free. The same applies to reimbursements for medical treatment of emotional trauma.
If your settlement is taxable, you’re generally taxed on the gross award… Without reduction for attorney fees. Say the lawyer who represents you in a case in which you are awarded $125,000 receives the money, deducts $37,500 in attorney fees and sends you a check of $87,500. The full $125,000 is taxable to you.
You generally can’t deduct the attorney fees…with limited exceptions. For example, a taxpayer may deduct lawyers’ fees on Schedule C if the underlying case was related to his or her business. Also, a plaintiff who receives damages or proceeds in connection with a legal action involving a claim of unlawful discrimination can take a write-off for attorney fees, thanks to a federal tax law that gives plaintiffs in these types of discrimination cases a deduction for such legal expenses.
This Tax Court case is a prime example of settlements and attorney fees. A couple sued multiple credit reporting firms under the Fair Credit Reporting Act, claiming the firms included inaccurate or incomplete information on credit reports. The couple hired a law firm, which negotiated a $64,750 settlement with the defendants. After attorney fees and other expenses, the couple received only about $5,000, which they included as income on their tax return. IRS claimed that the full $64,750, which was reported on Forms 1099-MISC filed by the defendants, is taxable to them. After reviewing the relevant law, the Court ruled that the couple is taxed on $64,750, and they can’t deduct any of their corresponding attorney fees (Eiler, 167 TC No. 3).
Contact us at Satty if you want to discuss how to handle your settlement.
