If you’ve won or settled a lawsuit this year, you need to be aware that some kinds of awards and settlements are taxable. Moreover, you will be taxed on the entire award or settlement, even though 30% or 40% may have gone to your lawyer. The Tax Cuts & Jobs Act increased the tax rate on qualifying awards and settlements.
If you do owe taxes on your award or settlement, you will generally receive an IRS Form 1099 the following year.
The ‘origin’ of your claim indicates how it will be taxed
Whether you owe taxes or not depends on what the award or settlement is meant to compensate you for. A personal injury case with no punitive damage award would generally not be taxable because the award is meant to compensate you for the loss of something you would otherwise have had. On the other hand, compensation for emotional distress is taxable, as are any punitive damages and interest.
An employment law claim where you were awarded wage compensation would be taxed as if the compensation were the wages themselves.
An award against a negligent builder, for example, might be taxed as a change in your property’s value.
The rules about the origin of claims are complex, so it’s best to bring in a tax lawyer as soon as possible to help you plan. If you’re in the midst of a trial or settlement talks, consider having a tax attorney explain the various tax repercussions ahead of time so you can minimize your taxation.
One thing a tax attorney might do in settlement negotiations is set up an agreement on specifically how the damages will be allocated. This would be simply listing that $100,000 is for physical injuries, for example, $50,000 is for property damage, $25,000 is for emotional distress and $40,000 is for lost wages. This agreement between the parties doesn’t bind the IRS, but the agency typically doesn’t ignore them altogether.
Can you deduct legal fees?
In some cases, yes. Specifically, the law allows you to deduct legal fees in certain whistleblower cases and employment claims. However, the Tax Cuts & Jobs Act not only increased the tax on litigation settlements but also disallowed the deduction of legal fees in most cases.
Talk to a tax attorney now
Ideally, you would have a tax lawyer involved in the structuring of any lawsuit settlement. Even if you did not do so, however, a tax attorney can help you minimize the taxes you owe. The rules are complex, however, so we recommend you contact your attorney right away.