Exploring the Tax Treatment of Legal Settlements and Ways to Reduce Taxation, on Settlement Payments
When individuals receive a settlement from a case it can offer financial relief. However, it also prompts considerations about the tax implications of these settlement proceeds. It is essential to grasp the tax consequences of settlements for those aiming to lessen the tax burden and steer clear of issues with the IRS.
This examination explores:
- The taxation of settlement payments
- Strategies for minimizing taxes on settlement
- Navigating the realm of taxing lawsuit settlements and awards.
It delves into when a settlement or award is subject to taxes explores methods for reducing tax obligations examines the differentiation between claims involving injuries versus physical injuries and underscores the significance of settlement agreements, Qualified Settlement Funds (QSFs) and Plaintiff Recovery Trusts, in mitigating tax implications related to legal settlements and awards.
Understanding How Legal Settlements Are Taxed
In general the key legislation governing the taxation of funds received from lawsuit awards and settlements can be found in Section 61 of the Internal Revenue Code (IRC).
This section of the code explains that “gross income includes all income, from any source…” unless another part of the code exempts the income source. Section 104 of the IRC excludes settlements and awards related to injuries from being taxed. However IRS guidance advises considering the circumstances of each settlement payment to accurately determine if it’s exempt from taxes as not all payments from an award or settlement are tax free.
Types of Judicial Awards and Settlements
Judicial awards and settlements are categorized into two groups to determine if the payments are taxable or non taxable. As, per IRS guidance one group covers claims related to injuries while the other group pertains to physical injuries.
Once funds are categorized into either of these two groups they are further divided into categories, typically including;
- Damages resulting from physical or non physical injuries
- Emotional distress damages stemming from the aforementioned injuries
- Punitive damages
- Compensatory damages
- Interest, on the awarded amount or settlement
It’s important to note that proceeds received as compensation for personal physical injuries or sickness are not considered part of the recipients gross income under IRC Section 104(a)(2). For compensations to be exempt from taxation they must be related to physical injuries or illness.
Also, remember that any reimbursement for expenses that were previously deducted is subject to taxation, and punitive damages are generally taxable unless awarded for death in states where only punitive damages can be granted.
Strategies to Reduce Tax Liability on Settlement Funds
Plaintiffs have options to minimize their tax liability on settlement funds. By allocating damages towards non-taxable categories such, as physical injuries and medical costs while decreasing amounts linked to emotional distress plaintiffs can lower their taxable income. Also, structured settlements provide a method to spread out payments, over years which could potentially help the recipient stay in a tax bracket and lessen the overall tax burden when compared to receiving a one time lump sum payment.
Qualified Settlement Funds (QSFs) offer the benefit of short term tax deferral and flexibility for recipients to decide how and when they receive their payments. They also allow defendants to claim a tax deduction. While QSFs do not directly lead to long term tax reductions they enable recipients to receive settlement payments over time as income or capital gains instead of in one large sum. This approach can substantially reduce the taxes owed by preventing the recipient from entering tax brackets in a year. Utilizing a QSF is recommended for every settlement as it helps with resolving liens and addressing settlement disputes.
It is crucial to seek advice from experts and tax professionals when dealing with the intricate tax implications of lawsuit settlements. Consulting with a settlement tax expert before finalizing an agreement or initiating action can offer valuable insights, into potential tax ramifications and assist plaintiffs in negotiating more favorable outcomes from a taxation perspective.
If its justified assigning damages, to taxable categories such as physical efforts to negotiate the reported amount on Form 1099 or spreading out the tax reporting of settlement payments over multiple years can be helpful in avoiding unfavorable tax consequences.
Keep in mind that claiming above the line income deductions for attorney fees often triggers IRS audit alerts leading the IRS to scrutinize the details of the legal claims. This is commonly referred to as the origin of the claim test. The IRS may use information from the claims to challenge a taxpayers exemption status. The outcome of the origin of the claim test will determine how legal fees are classified for tax purposes based on factors like whether the fees relate to matters, business activities, income generation or property interests. It is crucial to review the specifics of each claim and understand why an individual engaged an attorney – was it, for enforcing rights or pursuing legal actions? Answering these questions can help determine if the fees are not expenses business expenses, income related costs or expenses related to a capital asset. Despite some advisors suggesting otherwise it’s important not to overlook tax implications when categorizing these fees.
In the case of Commissioner, v. Banks in 2005 the US Supreme Court dealt with how a taxpayers attorney fees from a judgment or settlement should be taxed. The Court ruled that the full settlement amount, including the lawyers fee is considered income for tax purposes for the taxpayer. This means that attorney fees can affect a taxpayers tax responsibilities especially since the Tax Cuts and Jobs Act of 2017 restricted the deduction of fees. Strategies such as settlement annuities and Plaintiff Recovery Trusts can help reduce taxes and optimize outcomes.
Please note that it’s important for plaintiffs to seek expert tax guidance and structure their settlements with tax considerations in mind to safeguard their settlements from taxes.
Summary
In summary, while lawsuit settlements offer monetary relief, understanding tax implications is vital for maximizing the after tax settlement and avoiding IRS complications. By distinguishing between non physical injury settlements, using settlement agreements wisely and exploring options, like Qualified Settlement Funds and the Plaintiff Recovery Trust plaintiffs may lower their tax obligations. Connecting with experienced professionals like Eastern Point Trust Company is crucial when dealing with the complexities of settlement taxation.
