When you secure a financial settlement from a lawsuit, it's crucial to understand the associated tax implications. There are two primary types of damages you could receive from a lawsuit: compensatory and punitive. Each of these damages has different tax implications, which we will explore in this article.
Lawsuit settlements are financial awards granted to plaintiffs to compensate for their losses and/or to punish the defendant for their actions.
Compensatory damages compensate the plaintiff for the actual losses sustained due to the defendant's actions. These damages aim to restore the plaintiff's financial status as if the incident leading to the lawsuit had not occurred.
Economic damages are quantifiable monetary costs incurred by the plaintiff. These include medical expenses, property damage, and lost wages due to missed work.
Non-economic damages cater to intangible losses such as pain and suffering, mental anguish, and decreased quality of life. Assigning a monetary value to these damages can be challenging as they are subjective and vary from case to case.
Punitive damages punish the defendant for reckless behavior and deter others from committing similar acts. They are usually awarded in cases where the defendant's conduct was particularly egregious.
Taxability of Compensatory Damages
The reason for the award determines the taxability of compensatory damages. Generally, compensatory damages for physical injuries are not taxable income, implying that you do not need to report it as taxable income if your lawsuit settlement includes compensatory damages for bodily injuries.
However, non-physical injuries such as emotional distress, defamation, and humiliation are typically taxable income. See Plaintiff Recovery Trust for solutions to reduce taxation on settlements and Understanding Intricacies of Plaintiff Taxation.
Taxability of Punitive Damages
Unlike compensatory damages, punitive damages are always taxable, regardless of the reason for the award. They must be reported as "Other Income" when filing taxes. See Plaintiff Recovery Trust for solutions to reduce taxation on settlements and Understanding Intricacies of Plaintiff Taxation.
Tax Planning for Lawsuit Settlements
Tax planning is crucial before settling a lawsuit to avoid surprise tax bills. It's essential to know the breakdown of your settlement, and understand which portions of the damages are compensatory and which are punitive, for tax purposes.
Allocation of Damages
It's possible to allocate damages into compensatory and punitive categories to optimize tax treatment. While this allocation does not bind the IRS, the IRS usually does not ignore these agreements.
Attorney Fees and Taxes
If you hire a contingency fee lawyer, 100% of the money recovered is considered received by you for tax purposes, even if your lawyer takes a percentage off the top. Thus, you will be liable to pay taxes on the entire settlement amount, not just your share after attorney fees.
Understanding the tax implications of your lawsuit settlement can help you plan your finances better and avoid potential tax liabilities. It's always a good idea to consult with a tax professional or attorney to understand the tax implications of any damages you may receive.
And remember, the tax treatment of damages can be complex. So, having a knowledgeable industry leader to guide you through these complex financial matters is invaluable.