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How Your Legal Settlement Can Impact Your Taxes

  • Mar 01, 2021
  • The Harr Law Firm

Coin stacks in front of gavelWhen negotiating an amount for a legal settlement in any case, it’s important to consider not only the initial settlement amount, but the final amount you’ll receive after taxes and legal fees have been applied. What many people don’t realize is that most money received from legal cases is taxable by the US government. Keep reading to learn more about how your legal settlement will likely be taxed. We strongly recommend consulting with an accountant to get more specific information on taxation for your settlement amount.

What Types of Compensation Are Taxable?

First, it’s important to understand what types of compensation are considered taxable income, as not all income from a court case will necessarily be taxable. Compensation from most cases is broken down into three different types:

  1. Physical damages – This can be physical harm to your person or damage to your property. Typically, this type of compensation is not taxed. This would include compensation for physical pain and suffering, medical bills, restitution for damaged property, and similar, measurable losses.
  2. Emotional damages – Many court cases pertaining to injury also seek restitution for emotional pain and suffering. This could be sorrow at the loss of a loved one or extreme stress and anxiety related to an auto accident that prevents you from driving. This kind of compensation would be taxable.
  3. Punitive damages – When the actions of the defendant are particularly abhorrent, the court may award the plaintiff with punitive damages that are meant to deter the defendant from repeating those actions in the future. Punitive damages are always taxable.

The line between physical and emotional damages can sometimes get blurred. For example, if you’re under a great deal of stress related to your case, you might develop physical symptoms of that stress. Typically physical manifestations of emotional harm are not considered physical damages; thus, compensation for these would still be taxable. But determining whether symptoms like ulcers, migraines, and other stress-induced illnesses are symptoms of stress or a direct result of the accident can get murky. We’ll work to ensure that you receive the fairest compensation possible for all pain and suffering you’ve endured.

How Are Settlements Taxed?

Understanding which types of compensation are taxed is only the beginning to understanding how your legal settlement will impact your taxes. It’s also important to understand the way in which that income will be taxed, as different forms of income can be taxed at different rates.

The way your particular settlement will be taxed will depend on the “origin” of your claim. For example, if you’re pursuing compensation for lost wages, the portion of your settlement that is for those lost wages will be taxed just as your wages would have been taxed. If you’re suing for damages to your home due to a building contractor’s negligence, your recovery might not be considered income at all, and could be treated as a reduction in the home’s purchase price.

The rules and nuances surrounding how legal settlements are taxed are many and varied. And while we can help you to negotiate a compensation amount that will take taxes into consideration, we can’t provide advice on how to handle the taxes on this type of income. We encourage you to find a tax professional to help you work through the tax-related details of your case with you.

Who Pays Taxes on Attorney Fees?

Finally, it is important to understand that the amount you pay to us as your attorney will still be taxed by the US government. Many people who work with attorneys on a contingency-fee basis believe that if the defendant pays the lawyer’s portion of the settlement directly to the lawyer, then they will not have to worry about paying taxes on it. Unfortunately, this is not the case. The IRS recognizes the full settlement amount as income for you, and you will be taxed on the full settlement amount (minus any tax-exempt types of compensation, as previously mentioned).

How This Affects Your Case

So why do these tax considerations matter when negotiating your settlement amount? Many individuals who fail to plan for taxes on their legal settlements find themselves receiving very little compensation in the end. After attorney’s fees and taxes, some have ended up with next to nothing left for their troubles. This is why we strongly encourage you to speak with a CPA at the beginning of your settlement negotiations. Understanding the tax implications for your settlement income will help us to determine an amount that you believe will be fair to you, even after taxes have been applied.