Finally, you’ve received your legal settlement. Perhaps your car was wrecked or you suffered an injury – whatever damages you endured receiving your legal settlement or judgment brings some relief and recovery. But before you go out and spend every last penny, you need to understand the possible tax consequences so you don’t end up with an unexpected bill. Typically, legal settlements and judgments are considered taxable income; however, there are a number of things for you to consider below.
Payments to cover medical expenses are tax-free. Moreover, the definition of “medical expenses” in this context is broad, covering everything from psychiatrist and counselors to chiropractors and physical therapists. Qualified medical expenses can include many alternative treatments. However, if you claimed an itemized deduction for medical expenses related to the injury or sickness in prior years, you must include that portion of the settlement as taxable income.
Allocate Your Damages
Often, legal disputes involve multiple issues. In cases such as this, it can be beneficial for the plaintiff and defendant to reach an agreement on what is being paid and its tax treatment. While such tax assignment agreements are not officially binding on the IRS or in tax courts, they are rarely ignored in practice.
Consider the Defense
Defendants who end up paying a settlement or judgment always want to deduct it – but whether or not they actually can depends. In cases where the litigation involves the defendant’s trade or business, deductibility is rarely questioned and almost always allowed. If the lawsuit is investment related, the deductibility of a judgment may be limited against only investment income. In cases where the litigation is personal in nature, the defendant may not be able to deduct anything, including attorney fees.
Punitive Damages and Interest
Punitive damages and interest are always taxable. For example, if you are involved in a personal injury case and receive $3 million in punitive damages and $75,000 in compensatory damages, the $75,000 is tax free but the $3 million is taxable. Even attempting to deduct your attorney fees might not be allowed. Interest is treated similarly. While your settlement or judgment may be tax free, pre-judgment or post-judgment interest is always taxable.
Regardless of whether you pay your attorney hourly or on a contingent fee basis, you need to consider the cost of your attorney when it comes to taxes. Let’s look at an example. Assume you are the plaintiff and use a contingent fee lawyer. Usually, you’ll be treated as receiving all of the money even if the defendant pays your lawyer directly his contingent fees. If your case is fully nontaxable, there are no tax issues. But if your recovery is taxable, beware.
Assume that you receive a taxable settlement of $100,000 and your attorney keeps $30,000 as his contingency fee. Logic may dictate that you have $70,000 of taxable income; the total settlement less the legal fees. This is not quite the case. Instead you have $100,000 of taxable income and a $30,000 miscellaneous itemized deduction, which may or may not help come tax time, depending on a variety of limitation. From a practical perspective, miscellaneous itemized deductions are often of little tax benefit.
By the time you reach the end of the litigation road, you will likely be tempted to just be done with the whole ordeal. Remember however, that there are important tax consequences that you can influence and resolve as part of the process instead of just letting the chips fall where they may. You’ll be better off and glad you did come tax time.