In a tax malpractice case, beware of the tax consequences of a settlement. It may be possible to make part of the settlement tax-free.
Here is a list of ten items you should know about to help you understand the taxation of settlements.
1. The tax consequences are the same whether it is a settlement or a judgment.
2. Tax Consequences are based on the “origin of the claim.” If you sue your contractor for damage to your home, generally you won’t pay tax, but instead will reduce the purchase price of the home. If you sue strictly for sexual harassment and not for a physical injury, all of the proceeds of the settlement will be taxable. If you are in a car accident and recover for personal injuries and lost wages, none of the proceeds will be taxable. If your business is damaged by libel or slander, your damages may be taxed as capital gain.
3. Recoveries for physical injuries or physical illness are tax-free.
4. Symptoms of emotional distress are not physical injuries. However, PTSD has shown to cause physical changes to the brain and damages may be tax-free.
5. Recovery of Medical Expenses are tax-free.
6. It is important to allocate the damages in the settlement agreement. If you are suing for sexual harassment and you are awarded damages for a physical injury, depending on the facts you should consider allocating the damages. If you are being reimbursed wages, you should allocate whatever you are being reimbursed for to w-2 wages and the balance to emotional distress thereby saving yourself some a share of employment taxes.
7. You may have capital gain instead of ordinary income.
8. Attorneys fees is a tax trap for damages that are taxable and if it is a sexual harassment suit, beware of signing any confidential agreement.
9. Punitive damages are always taxable.
10. The defendant would like to deduct the payment. You can have a win-win situation, if the defendant is permitted to deduct the damages.
11. Sexual harassment and abuse: Under the new tax law, confidential sexual harassment or abuse settlements face special tax rules. If the settlement is confidential, the defendant cannot deduct the settlement payment or the legal fees. As written, this no-deduction rule seems to apply to plaintiff legal fees too.
Most sexual harassment cases arise in the employment context, in which an above-the-line deduction for plaintiff legal fees applies. But this deduction is now called into question. That surely unintended result for plaintiffs may be corrected. The pending “Repeal Trump Tax Hike on Victims of Sexual Harassment Act of 2018” would do so.
No plaintiff wants to pay tax on 100 percent of his or her recovery and receive only 40 percent of it. Some plaintiffs insist on omitting the nondisclosure provision or a tax indemnity if they have their tax deduction for legal fees denied. Others agree to a set (usually small) amount of the settlement being allocated to sexual harassment. But this may be unrealistic when the whole case is about sexual harassment, and there is no guarantee the IRS will agree.
David Lee Rice, A Professional Law Corporation, regularly advises defendants on the tax consequences of their litigation matters. When a defendant makes a payment to a plaintiff for a physical, then the payment is generally not taxable, and a Form 1099 should not be issued. Each case is different, though, so you should contact your tax advisor for a consultation.
Structured Settlements
A structured settlement is the payment of money to settle a claim where the recipient of the payment receives future payments instead of, or in addition to, a single upfront payment. Structured settlements may consist of installment payments and future lump-sum payments, and may be scheduled for any length of time. The settlement’s payment schedule is structured to meet the financial needs and objectives of the injured individual.
Today, it is fairly common for lawsuit recoveries in personal injury actions to stretch well into the seven-figure dollar amounts:
1. $31 million to a young girl with traumatic brain injuries after a collision with a speeding, intoxicated driver. Landeros v. Torres, Kern County Superior Court.
2. $5,322,356 when a worker was fatally electrocuted at a packaging plant after cutting into a cable that was supposedly de-energized. Confidential v. JCJ Electric Inc., Monterey County Superior Court.
3. $1.85 million to a woman working in the cold storage area of a warehouse after she was struck and injured by a forklift. Zegerman v. NZG Specialties Inc., Los Angeles County Superior Court.
These amounts, received on account of personal physical injury or physical sickness, are excludable from the recipient’s income. However, what about the future earnings on the excluded recoveries and the ability of the recipient (or his financial advisors) to effectively manage such a large sum of cash? Structured settlements provide continued tax benefits to recipients, while also providing a stable and secure stream of payments for several years into the future.
David Lee Rice, A Professional Law Corporation, works with clients and their advisers on all aspects of litigation. If you have suffered a personal injury, are involved in business litigation or are interested in learning more about structured settlements, please contact us for a consultation.
