by Michael Wiener, E.A.
Your contractor did shoddy work on your condo. You were unfairly fired. If you are collecting a settlement or judgment, is it taxable income? Usually yes, but taxes vary enormously depending on how you were damaged, how the case was resolved, and even how checks and IRS Forms 1099 were issued.
Here are some concepts you should know. Settlements and judgments are taxed the same. The same tax rules apply whether you settle or win a judgment. If you are audited, you’ll need to show the settlement agreement, complaint, checks, IRS Forms 1099, W-2, etc.
Settlements and judgments are taxed according to the “origin of your claim.” For example, 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, you’ll be taxed on wages. Your former employer will probably withhold income and employment taxes even if you no longer work there.
Recoveries for personal physical injuries and physical sickness are tax-free. If you sue for personal physical injuries, your damages are tax-free. Most importantly, the Tax Code states that in order to qualify for tax-free treatment your injury must be “physical.” Symptoms of emotional distress are not “physical.”
Money you receive for physical symptoms of emotional distress (like headaches and stomachaches) is taxed, while physical injuries or sickness is not.
For example, if in settling an employment dispute you receive $50,000 extra because your employer gave you an ulcer. Is an ulcer physical, or merely a symptom of emotional distress? Many plaintiffs take aggressive positions on their tax returns, claiming that damages of this nature are tax-free. But that can be a losing battle if the defendant issues an IRS Form 1099 for the entire settlement. You may want to try to agree with the defendant about the tax issues.
Medical expenses are tax-free, even if your injuries are purely emotional. The definition of “medical expenses” can be surprisingly liberal. For example, payments to a psychiatrist or counselor qualify, as do payments to a chiropractor or physical therapist. Many nontraditional treatments can count as well.
Punitive damages and interest are always taxable. If you are injured in a car crash and get $50,000 in compensatory damages and $5 million in punitive damages, the former is tax-free. The $5 million is fully taxable, and you can have trouble deducting your attorney fees.
Attorney fees can be a trap! Whether you pay your attorney hourly or on a contingent fee basis, factor in the cost of your attorney when you’re addressing taxes. Say you settle a suit for intentional infliction of emotional distress against your neighbor for $100,000, and your lawyer keeps $40,000. You might think you’d have $60,000of income. Instead, you’ll have $100,000 of income, followed by a$40,000 miscellaneous itemized deduction. You’ll be subject to numerous limitations-and to the alternative minimum tax or AMT that can whittle your deduction down to nothing.
Bottom line: It can be tempting to end your dispute and let the tax chips fall where they may. But before you resolve it, consider the tax aspects. You’ll almost always have to consider them at tax return time the next year. You’ll be better off considering taxes earlier, and may save yourself serious money.
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