TAX CONSEQUENCES OF SETTLEMENTS AND JUDGMENTS
As a plaintiff, you have retained counsel, participated in the litigation process, and have reached a settlement or obtained a judgment against the adverse and responsible party. At this point, the question of tax consequences is rarely asked or the consequences of money received discussed with counsel. If there are indeed tax consequences, they will have to be reported.
This is even more significant with higher taxes on lawsuit settlements since the tax reform laws passed in late 2017. As a plaintiff/litigant, discussions with counsel in advance of settlement, essentially tax planning, are important issues to consider.
There are five specific items that must be considered in determining the tax consequences of a settlement or judgment:
1) The tax will depend upon the “origin of the claim”. If the recovery is designated as compensation for wages or emotional distress, there will generally be tax consequences.
2) Recovery for physical injuries/physical sickness is tax free. Prior to 1996, all “personal injury damages” were tax free, including emotional distress and defamation type of damages. Since 1996, the injury must be “physical”. As stated previously, litigation for intentional infliction of emotional distress, with recovery on that basis, is generally taxed. While there may be some confusion as to whether damages are physical or emotional, this issue should be resolved at the time of executing the final settlement documents.
3) Plaintiffs and defendants should agree on tax consequences prior to completion of the settlement. Although such agreements are not binding on the IRS or Franchise Tax Board, prior agreements may not be disputed.
4) Be aware of attorneys’ fees. Attorneys’ fees are a trap. Generally a litigant may be taxed on 100% of the money recovered, including the portion obtained by the attorney. This will depend upon the nature of the case. However, if the case if fully non-taxable, such as a personal injury settlement from an automobile accident, there should not be any cause for tax problems as it applies to attorneys’ fees.
5) Punitive damages and interest are always taxable. If you recover punitive damages (punishment) in addition to compensatory damages, and/or you obtain a settlement that includes interest, those portions of a settlement will indeed be taxable. Interest issues can also create a problem in determination of attorneys’ fees.
The moral of the story is that generally personal injury settlements, alone, are non-taxable. If the settlement includes compensation for wages, punitive damages, interest, or attorneys’ fees, the litigant should confer with either the retained attorney in advance of executing a release /settlement agreement, or seek a consultation with a tax lawyer skilled and knowledgeable on the issue of tax consequences of settlements and judgments.
This article is not intended as legal advice. Every case is different, as are the tax consequences of any settlement and/or judgment.