How Does the IRS Tax Money Awarded in a Lawsuit?

September 19, 2019

A judge and jury awarded a man $248 million in a lawsuit, but he only took home $18 million. Why!? How!? Answer: Taxes! Yes, federal and state authorities take a cut of lawsuit damages. That’s why it’s essential to consider tax implications during settlement talks.

Below, we break down how it works, without all the legalese.

Seven Facts Regarding Lawsuit Taxation

  1. The IRS taxes some lawsuit awards. Lawsuit taxes are based, in part, on the “origin of the claim.” If you sue for back wages, you’ll likely have to pay income tax on the reward. However, if you sue for condo damages or personal injury costs, it may be tax-free.
  2. The IRS typically doesn’t tax personal injury damages. Real damages paid to physical injury victims are generally tax-free because the money goes towards related medical costs. However, emotional distress damages don’t fall into the bodily injury category. Before 1996, emotional distress counted as a tax-free injury, but no longer.
  3.    What about awards related to “intentional infliction of emotional distress?”Uncle Sam usually takes a cut of damages associated with intentional inflection of emotional distress. Physical symptoms like headaches and stomach aches are taxed; physical injuries and sickness aren’t.
  4.    Get it all in writing. It’s good practice to put tax implications in writing when settling a claim between defendants and plaintiffs. Though the IRS isn’t bound to lawsuit agreements between third parties, the agency pays attention to them. In case of further conflict, such notes and clauses can be a powerful pieces of backup evidence in tax-related hearings.
  5.    You’ll likely have to pay taxes on your attorney’s cut. In cases where attorney’s fees are deducted from the award, the plaintiff may still owe taxes on the attorney fees. So, let’s say you win $100,000 and your attorney takes $40,000 as payment, you’re responsible for paying taxes on the $100,000 amount. (Note: This doesn’t apply to nontaxable lawsuit settlement amounts.)
  6.   The TCJA included lawsuit taxation changes. The Tax Cut and Jobs Act contains a new litigation settlement tax plus a clause that disallows legal fee deductions.
  7. Punitive damages are always taxable.

Connect with a Tax Law Attorney

When negotiating lawsuit settlements, keep related tax obligations in mind. Better yet, work with an attorney who is skilled in tax law.

Do you need to consult a tax law attorney? Get in touch today.



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