Tax Deductions for Legal Settlements

What is a Legal Settlement?

Legal Settlements are monetary payments made to settle a legal dispute. These disputes can arise from personal injury, property damage, harassment or discrimination and can occur over business contracts, break of agreement between business partners or some other reason. Legal settlements can arise from many different types of disputes.
For example, consumers may enter into a legal settlement with a corporation because a product was defective or caused harm in some way. Employees may sue their employer for workplace harassment or discrimination and settle for remuneration . A slip and fall outside a store may lead to a lawsuit or the neighbor’s tree falling on your house. The outcome of a legal dispute may provide for compensatory damages, punitive damages or some combination of both that lead to a legal settlement being made between the parties. The type of damages awarded by the court depends on the issues between the parties that led to the legal dispute in the first place.
In short, any legal issue that falls short of being resolved in court, but leaves the other party in some need of compensation, may result in a legal settlement between the parties.

Basic Tax Rules for Settlements

Unfortunately, not every settlement is free from potential taxation. The general rule for settlements, however, is that they are non-taxable if they are intended to make the victim whole. For instance, money received from a settlement or both physical injury and physical sickness is usually non-taxable, and neither is a settlement for emotional distress or a wrongful death.
The IRS allows that money received from a lawsuit may be non-taxable if it is "damages received on account of personal physical injuries or physical sickness." In the 1989 case U.S. v. Burke, the U.S. Supreme Court considered the tax implications of a settlement award for a teacher who had been discriminated against by her school district. The school board administrators reached a settlement with the teacher in which the teacher agreed to release her claims against the Board but that she would not be taxed on the funds she received for the portion of the settlement representing back pay, back benefits, and interest thereon. The court held that the payment for lost wages was earmarked as income in settlement, and therefore was taxable, since the plaintiff could have issued the check directly to her home address instead.
As is evident from the U.S. v. Burke decision, courts tend to base their reasoning on the meanings of language contained in a settlement agreement. In the words of the court, "Settlements are construed like a contract, so courts must look to their language for interpretation, and they should enforce an unambiguous contract according to its plain terms, even if the result is harsh. Courts do not look their intent when construing a settlement agreement." This language has become well-cited precedent in other cases, and often governs whether or not a settlement will be taxed.

When Settlements are Tax Deductible

If you are a business, and you have to settle a dispute, the settlement generally should be deductible on your profit and loss for the tax year in which you paid it. That is because the payment arises from the normal course of your business. The settlement payment likely was made out of a desire or need to keep violating a law or to gain or retain business. In addition, so long as the payment was not illegal, and it generally will not be if you violated a civil law or a regulatory law under which you also were likely to have criminal liability, the payment is (unless the law says otherwise) deductible as arising from your ordinary and necessary business expenses.
You cannot deduct payment for various civil or regulatory laws’ violations or payments made in lieu of fines that would be imposed if you actually had violated the laws, again so long as the payment was not illegal. Your payment also would not be deductible if it arose out of a violation of a criminal law in which you either were prohibited from making the payment or if its purpose was to further the violation or although not illegal to corrupt public officials.
Illegal payments and payments arising from criminal misconduct do not give rise to a deduction. Only legal payments are deductible for violating laws and regulations.

Types of Settlements and Their Tax Implications

The types of settlements you receive also dictate whether you receive any deductions for your taxes. Payments for personal injury, wrongful death, and physical sickness are exempt from being taxed as income and fall under the exclusion rule, meaning that you do not have to report it, only if you have not been previously compensated for those costs. So, even if you are awarded $10 million and only injured less than a few thousands dollars you still will not have to pay taxes on $9 million. This only applies to the settlement amount directly related to your injury, for example, medical bills including prescriptions and all doctor visits or disability payments. The issue arises however, when your business was damaged due to your injury or the injury infected your ability to work, then the payment you receive may be subject to tax. Personal injury settlements, unlike employment settlements, can be divided between physical damage and damage to your career or business. This means that you can avoid taxation on your physical injury but still retain the award that will be subjected to tax. So the key is to seek guidance as to how to divide your settlement award into damages for physical injury and damages for damages to business or loss of reputation. Under 26 U.S.C. § 104(a)(2), you are not required to report amounts received for personal physical injuries or physical sickness, but these amounts are also not deductible for your personal tax purposes. These exclusions also apply to the companion under 26 U.S.C. § 104(a)(2), which states that amounts received through compromise, judgment or settlement do not need to be reported as income or earnings. Although there are exclusions from income, that does not mean the exclusions are deductible; according to McAngus, Goudelock & Courie v. Little, no exclusions from income are deductible, making it beneficial to find the settlement that offers the most exclusions in claim. However, the exclusion only applies to amounts awarded for physical injury, but not to emotional distress items, such as pain and suffering, loss of consortium, or loss of reputation. Even if you do receive compensation for pain and suffering, that amount is still subject to taxation. The difference between negligence and intentional conduct also plays a role in whether the payments made to you will be either taxable or non-taxable. In addition to the negligence versus intentional act rule, any payments made through punitive damages are always taxable.

How to Report & Document Settlements

Taxpayers should ensure that a proper reporting of the settlement proceeds is provided to the IRS by the payer, and any corporation, government unit, or exempt entity or person is required to report all or any portion of the settlement amount on Form 1099-MISC in the applicable box. If the settlement directly relates to the taxpayer’s trade or business, the payment will likely be reported in box 7 on Form 1099-MISC as nonemployee compensation. However, in some cases, such as a settlement based on an alleged failure to comply with the Fair Labor Standards Act, the settlement may relate to wages yet still be reported in box 3 as other income because the payment does not qualify as "remuneration for services."
If the settlement proceeds are paid to a trust or an estate, the trust or estate is considered the payee and must report the settlement proceeds on its income tax return. If the settlement proceeds are paid to a decedent’s estate, the executor is required to issue the information return on behalf of the estate. See Rev. Proc. 85-4, 19852 C.B. 669. If a deceased taxpayer’s estate is closed prior to the settlement payment, see Rev. Proc. 95-40, 1995-2 C.B. 148, for guidance.
The settlement of litigation may involve the disbursement of funds to a relator’s counsel and the relator, as well as the government as a whistleblower award. Entity taxpayers must determine the portion of the proceeds attributable to the relator , and will report the relator’s portion under the rules for information reporting for payments to corporations. See I.R.C. § 6041. Individual taxpayers must report the relator’s portion on Schedule K-1 (Form 1065) as guaranteed payments subject to self-employment tax.
Taxpayers should also ensure that they document their payment to plaintiffs’ or their counsel for their share of the settlement proceeds. Specifically, if the settlement proceeds are attributable to the taxpayer’s production of income, then the payment should be classified as a deductible ordinary business expense under I.R.C. § 162; if the proceeds are attributable to a capital asset, then the payment should be basis adjusting or allowable as a secret formula expense under I.R.C. § 177.
In addition, taxpayers wishing to potentially preserve a deduction for attorney’s fees and/or court costs should be cautious when making payments to third parties. The general rule is that taxpayers may deduct legal expenses if they were made in carrying on a trade or business or for the production of income. However, [i]f the payee intends to reimburse the client for these costs, the deduction could be lost if the client pays the third party directly rather than through the attorney or other representative. Since contingent-fee arrangements usually require payments to be made to attorneys who are then responsible for paying any court costs and reimbursing these costs to the client (if applicable), payments to counsel for attorney’s fees and costs may qualify.

Potential Pitfalls and Errors

Common Pitfalls and Mistakes in handling Taxes for Settlements
One mistake, which we have seen from time to time, is for people to assume that their decrease in emotional pain is worth more than the taxes they will have to pay on the settlement. In other words, the tax burden "settles" their grievance. There are two main reasons this mistake happens. First, many people really do not understand how much they will need to pay in taxes on the settlement. Often, they have been told that it will be taxed at about 20% or 25%. Unfortunately, this is not even close because of the alternative minimum tax. The entire settlement could be taxed more than 50%. The second problem is that people do not consider the long term costs of the taxes. For example, a $100,000 settlement, which would be taxable at 50%, could require you to pay $50,000 which, if invested for a period of 5 years at 5%, would yield an additional $12,625 in taxes (i.e. $62,625 becomes $75,250). If you received a marital settlement of $400,000, your taxes would likely be owed on at least $200,000 of those dollars and, with only a 3 year return rate at 5%, the taxes would cost you $31,626.
Another mistake often error is to try to convert money into separate property by stating it is non-taxed money. For example, if money from a partnership is received in lieu of a partnership buyout, it is taxed. Your agreement must state the money is for "lost value" (as opposed to reimbursing them for an actual "out of pocket" expense such as a payment on a credit card) for it to be tax-free.
Sometimes people do not report the non-taxable money correctly; even though it would be the correct amount. The IRS computer systems have gotten very good at even catching non-taxable transactions. For instance, suppose your husband declares that money in the amount of $20,000 for the sale of a business that he owned with a partner, are actually funds solely for his half of the business. Therefore, none of the money from the sale of the business would be community property. After settling and transferring the $20,000 into a separate bank account, he receives a Form 1099 showing the $20,000 gross amount was income to him as a sole proprietor with his Contractor’s license. Even though the taxes were already paid for the sale, if he fails to report the full amount of income on his personal income tax return, then the IRS could send a notice back demanding all additional taxes owed to them. Meanwhile, he would have no proof to give to them as to why the tax return did not match the 1099.

Seek the Help of Tax Professionals

Employing the services of a competent tax professional can be an invaluable asset when it comes to understanding and handling the tax implications of a legal settlement. Not only can these individuals provide insight as to what types of earnings are taxable, they can also offer guidance on how to use a settlement to your benefit and even suggest ways to minimize the taxes that have to be paid on the monetary award. Because potential tax penalties can be costly, it is essential that an individual understands if and how a settlement will affect their tax situation. Unfortunately, many people go through the legal process without realizing the consequences of the settlement agreement until much later on. In certain legal situations, an individual may be able to defer taxation of the settlement by taking advantage of a provision in the tax code. However , to utilize these provisions, one must be certain of the tax classification of the award. Again, this is where the services of a tax professional come in handy. In addition to providing legal counsel, a lawyer can assist in determining how a settlement should be processed. As with many complex areas of the law, suits involving tax considerations are best handled by a professional who has expertise in the field. Just as you would not perform your own surgery or restore a priceless painting, those who are unfamiliar with tax laws should likewise not interpret them in the context of a settlement agreement without consulting with a professional who is savvy with interpret and apply the relevant laws. Failure to hire an attorney and tax professional may result in costly decisions.