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Understanding Tax Implications on Different Types of Lawsuit Settlements

November 21, 2023

This article explores the tax implications of compensatory and punitive damages from lawsuit settlements. Learn about taxability, planning, damages allocation, and attorney fees' role in tax liabilities.

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.

Overview of Lawsuit Settlements

Lawsuit settlements are financial awards granted to plaintiffs to compensate for their losses and/or to punish the defendant for their actions.

Types of Lawsuit Damages

Compensatory Damages

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

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

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

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.

Tax Implications of Lawsuit Settlements

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.

Conclusion

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.

For a comprehensive overview of tax minimization strategies, see our guide on minimizing tax liability on lawsuit settlements.

Learn how the Plaintiff Recovery Trust addresses the attorney fee double tax created by Commissioner v. Banks.

Frequently Asked Questions

Under IRC § 61, all income from whatever source derived is taxable unless a specific exclusion applies. Lawsuit settlements are included in gross income by default. The key exceptions are physical injury and physical sickness recoveries under IRC § 104(a)(2), which are excluded from gross income when received as compensation for a physical injury or physical sickness claim.

IRC § 104(a)(2) excludes from gross income damages received on account of personal physical injuries or physical sickness. The exclusion applies to compensatory damages only. The injury or sickness must be physical — emotional distress damages, employment discrimination recoveries, breach of contract proceeds, and punitive damages do not qualify for the exclusion and are taxable.

Yes. Punitive damages are taxable as ordinary income regardless of whether the underlying claim involves a physical injury. IRC § 104(a)(2) does not exclude punitive damages. Even in a physical injury case where compensatory damages are excluded, any punitive damages awarded are included in the plaintiff's gross income and subject to federal income tax.

For most plaintiffs, no. The Tax Cuts and Jobs Act of 2017 suspended miscellaneous itemized deductions under IRC § 67(g) for tax years 2018 through 2025, eliminating the attorney fee deduction for most civil litigation recoveries. IRC § 62(a)(20) provides an above-the-line deduction only for qualifying discrimination and whistleblower cases. Plaintiffs in personal injury, breach of contract, and most tort cases cannot deduct attorney fees under current law.

A Qualified Settlement Fund (QSF) under IRC § 468B separates the timing of the defendant's payment from the plaintiff's taxable receipt of funds. The defendant transfers proceeds to the QSF and takes an immediate tax deduction. The plaintiff does not recognize taxable income until distribution from the QSF, preserving a planning window to implement structured settlements, Plaintiff Recovery Trusts, Special Needs Trusts, or other tax-minimization strategies before receiving taxable income.

A Plaintiff Recovery Trust (PRT), administered by Eastern Point Trust Company, addresses the attorney fee double tax created by Commissioner v. Banks, 543 U.S. 426 (2005), and worsened by TCJA 2017. The PRT separates the attorney fee portion of the settlement from the plaintiff's taxable recovery, allowing each party to recognize income only on their respective portion. Eastern Point Trust Company has saved plaintiffs $30 million or more through PRT structures. The PRT is implemented during the QSF administration window before taxable distributions occur.

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