How Legal Settlements and Judgments Are Taxed
| Publication year | 2017 |
| Author | Robert W. Wood |
Robert W. Wood
Robert W. Wood is a tax lawyer with www.WoodLLP.com, and the author of numerous tax books, including Taxation of Damage Awards & Settlement Payments (www.TaxInstitute.com). This discussion is not intended as legal advice.
Lawyers and clients resolve disputes all the time, usually with an exchange of money and a release. Of course, almost any time money changes hands, there are tax issues, too, usually for both sides. Most lawyers rightly tell their clients that they are not tax advisers, and that it is worth seeing a tax lawyer or accountant to get straight on the tax implications.
Yet, after such a disclaimer, some lawyers do succumb to the temptation to offer some free tax advice. For example, the lawyer might say, 'I'm not a tax lawyer, but don't worry, all these damages are non-taxable.' But whether you are a lawyer or a client, a basic grounding in these issues will help you, not only with your own taxes, but possibly with colleagues' taxes too.
The tax issues come up in a surprising number of ways. Your car got rear-ended while stopped at a red light. Your contractor did shoddy work on your condominium. You were unfairly fired. Someone did you wrong, and now you're collecting a settlement payment or judgment. The first question in any of these situations is whether the settlement (or judgment) you get is taxable income. Usually, the answer is yes.
Of course, the tax treatment can vary enormously, depending on how you were damaged, how the case was resolved, how the checks and IRS Forms 1099 were issued, and other variables. Here are ten rules lawyers and clients should know about the taxation of settlements.
The same tax rules apply whether you are paid to settle a case or win a lawsuit judgment, or even if your dispute only reached the letter-writing phase. Despite the similarities, though, you'll almost always have more flexibility to reduce taxes if a case settles rather than goes to judgment.
If you are audited, you'll need to show what the case was about and what you were seeking in your claims. Consider the settlement agreement, the complaint, the checks issued to resolve the case, IRS Forms 1099 (or W-2), etc. You can influence how your recovery is taxed by how you deal with these issues.
Settlements and judgments are taxed according to the item for which the plaintiff was seeking recovery (the "origin of the claim").1 If you're suing a competing business for lost profits, a settlement will be lost profits, taxed as ordinary income. If you get laid off at work and sue for discrimination, seeking wages and severance, you'll be taxed as receiving wages. In fact, your former employer will probably withhold income and employment taxes on all (or part of) your settlement. That is so even if you no longer work there-- even if you quit or were fired years ago.
On the other hand, if you sue for damage to your condominium by a negligent building contractor, your damages usually will not be income. Instead, the recovery may be treated as a reduction in your purchase price of the condominium. That favorable rule means you might have no tax to pay on the money you collect.
However, these rules are full of exceptions and nuances, so be careful. Perhaps the biggest exception of all applies to recoveries for personal physical injuries.
This is a really important rule, and one that causes almost unending confusion with lawyers and their clients. If you sue for personal physical injuries, like a slip and fall or car accident, your compensatory damages should be tax-free. That may seem odd, since you may be seeking lost wages because you couldn't work after your injuries.
But a specific section of the tax code—section 104—shields damages for personal physical injuries and physical sickness.2 Note the "physical" requirement. Before 1996, "personal" injury damages were tax-free. That meant emotional distress, defamation, and many other legal injuries also produced tax-free recoveries. That changed with the 1996 amendments to the key tax code provision.3
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Since then, your injury must be "physical" to give rise to tax-free money. Unfortunately, neither the IRS nor Congress has made clear what that means. The IRS has generally said that you must have visible harm (cuts or bruises) for your injuries to be "physical."4 This observable bodily harm standard generally means that if you sue for intentional infliction of emotional distress, your recovery is taxed.
If you sue your employer for sexual harassment involving rude comments, or even fondling, that is not physical enough for the IRS. But some courts have disagreed. The tax court, in particular, has allowed some employment lawsuits complete or partial tax-free treatment, where the employee suffered physical sickness, or the exacerbation of a pre-existing illness, from the employer's conduct.5
Thus, standards are getting a little easier. However, taxpayers routinely argue in U.S. Tax Court that their damages are sufficiently physical to be tax-free. And the IRS...
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