How Much Taxes You Pay On Lawsuit Settlements

Disclaimer: We are not qualified tax professionals and are not giving advice. Always speak with a qualified professional before making any legal or financial decisions.

If you have just won a lawsuit and been awarded money, it is probably not all yours. A good portion might belong to your lawyer, possibly to a medical facility, and depending on the type of lawsuit settlements, the government may take a percentage. Knowing when taxes are due is crucial to avoid penalties. It's essential to understand the implications of not paying taxes, as there are serious consequences, such as going to jail for not paying taxes. In this article, we'll examine lawsuits, taxes, and ways to decrease your tax burden.

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What Types of Lawsuits are Taxed?

In general, lawsuits that deal with wages are treated as wages. A lawsuit that deals with injuries or damages is not. However, this is not cut and dry, so always speak with a professional to determine how your lawsuit settlements are laid out and how the damages are allocated.

The tax of lawsuit settlements depends on the origin of the claim. The claim is the reason you are suing and can have different facets. Depending on what you claim and what you are awarded, all or part of it may be taxed. For instance and in general:

• Recovery of wages - taxed as wages
• Negligent emotional distress - taxed
• Damages to a structure - probably not taxed
• Physical injuries or physical sickness - probably not taxed
• Intentional infliction of emotional distress - taxed
• Punitive (punishes the defendant) damages - taxed
• Employment discrimination - taxed
• Copyright infringement - taxed
• Pre-judgment or post-judgment interest - taxed
• Legal fees - may or may not be deducted from the taxable amount
  

This list is not complete and has a lot of nuances and exceptions! Speak to a qualified tax professional!

Signing the Form

Before you settle a lawsuit, you will be asked to agree to the terms. Try to have the lawsuit settlements allocated to specific damages. For instance, if there is a physical illness reimbursement, have that detailed out. The more money you can have assigned to non-taxable awards, the lower your tax burden will be. Get tax advice from a qualified CPA or tax lawyer. While this document is not binding for the IRS, it is usually taken into consideration by the IRS. 

Before the end of the tax year, you will receive a Form 1099 for the lawsuit. Keep this. You will need it for your taxes. If you have questions about IRS Form 1099-C or Form 982, you can learn more about how to use IRS Form 982 and 1099-C for cancellation of debt and understand Form 982 and Form 1099-C in detail.

Reporting Your Debt Settlement to the IRS

Once you receive your settlement funds, you will need to report the amount to the IRS by filing Form 1040 and Schedule C. Here's what to do:

• Report the full settlement amount on Line 21 of Form 1040, even if your attorney's fees were deducted.
• Include any interest received on Line 2 of Form 1040.
• Complete Schedule C to report your attorney fees and other legal expenses related to the lawsuit. These fees may be deductible.
• Attach a statement to your tax return explaining the details of your lawsuit settlement and referencing any related Forms 1099.
• Pay estimated taxes on your settlement to avoid penalties. You may need to make quarterly estimated tax payments.
• Consider amending prior year tax returns if your settlement is related to losses claimed in previous years.

Properly reporting your settlement will avoid problems with the IRS down the road. Consult with a tax professional for guidance.

Settling Versus Judgment

Lawsuit settlements can offer some tax advantages when settled out of court. For instance, any prejudgment or post-judgment interest on the award is taxable, even if the award itself is not. Additionally, you may not necessarily receive more money by going to court. Opting for lawsuit settlements can often provide a quicker resolution and potentially lower tax implications.

These settlements allow for more control over the outcome and can be structured in ways that may be more tax-efficient. An experienced attorney can guide you through the choices between settling out of court and proceeding to trial, helping you make the best decision for your situation while considering both the financial and tax aspects of your case.

How Much is Taxed?

Once you win a lawsuit, the legal firm representing you takes a portion. This portion usually ranges between 33% for lawsuit settlements and 40% for going to court. For example, if you win a lawsuit settlement of $100,000, the lawyers may take $33,000 if you settled or $40,000 if you went to court before passing the remainder to you. 

Previously, legal fees could be deducted, but in 2004, Congress limited deductions to legal fees on employment claims and some whistleblower claims. This area of the law is subject to changes, so it's essential to consult with a qualified CPA for up-to-date information on deductions related to lawsuit settlements. The amount you pay in taxes depends on your tax bracket. A CPA or qualified tax professional can provide valuable advice and guidance to ensure compliance and optimize your financial outcome.

How Are Lawsuit Settlements Paid?

There are several steps you will need to follow to get your money. Read all the paperwork carefully. 

• Signing documents or release forms - these depend on your claim. You are asked if you agree that the settlement amount is accurate and may be asked to sign a non-disclosure agreement or agree that you will not sue the defendant again. 
• Once the forms are signed, the check is released by the insurance company 
• The legal representative will pay off any liens against the plaintiff (you), such as medical expenses
• The legal representative then pays off any legal fees or court costs
• The plaintiff (you) gets whatever is left
• At the end of the tax year, you get a 1099 and must file taxes including your lawsuit settlements or judgment

Depending on how your compensation was allocated, there may not be a great deal left over. It's important to remember the purpose of the money from lawsuit settlements. For instance, if you have long-term medical expenses due to paralysis, these funds need to be used for your support and medical treatment.

 Spending the settlement on luxury items like new cars for relatives or an in-home theater system is likely unwise. To make the most of your lawsuit settlements, consider consulting a qualified investment advisor who can guide you in managing these funds responsibly.

Lump Sum or Structured Lawsuit Settlements

You may be asked if you want a lump sum or a structured settlement. There are benefits and drawbacks to each. Let’s take a deeper look at these and which you may want to consider. 

*As always, we are not tax professionals, so speak with a qualified tax professional before making your decision.

A lump sum payment is just that. You get the entire amount at once. Consider a lump sum for smaller settlement amounts or if there are no long-term medical issues. Think about the following when deciding on a lump sum:

• Often a larger sum than the structured settlement amount
• Easier to invest or pay off debts
• A sudden influx of large amounts of money can be overwhelming
• May lose a lot of money through inexperience
• May have a greater tax consequence
• Company/individual may not be willing to reach an agreement for a lump sum

A structured lawsuit settlement means that you get a certain amount of money over a certain period. Consider a structured settlement for large settlement amounts or in cases of long-term medical issues. 

Think about the following when deciding on a structured settlement:

• May be able to decrease your tax consequence
• Dedicate funds for medical treatments and care
• May help plaintiffs and defendants reach an agreement on the amount of the judgment
• Inflation may drive down the value of the settlement
• If the defendant or defendant’s insurance company declares bankruptcy, the settlement fund is no longer available.
  

Some companies buy out structured lawsuit settlements in part or in full. These companies offer a lump sum for all or some of the settlement amount. Approach these offers with great caution. You may end up with a tax burden or other issues that diminish your money. Do your research before you decide to sell your structured lawsuit settlements. At Pacific Debt Relief, we understand the complexities of choosing between a lump sum and a structured settlement. Our team can provide you with the necessary guidance to make informed financial decisions that best suit your needs and long-term goals.

Getting Help From Tax Professionals

With the complex tax implications of lawsuit settlements, most people can benefit from getting tax advice. Here are some options to consider:

• Hire a CPA to prepare your tax return and optimize your settlement. A CPA can guide you through the reporting process.
• Consult a tax attorney for legal advice on the taxability of your specific settlement. An attorney can review your case details.
• Get advice from an enrolled agent (EA) on managing tax payments. EAs are licensed by the IRS to represent taxpayers.
• Use a low-cost tax preparation service to file your return. Services like TurboTax can walk you through reporting your settlement.
• Ask your attorney for a referral to a reputable accountant. Your attorney may have colleagues they work with regularly.

With the right tax help, you can properly report your settlement, reduce your tax burden, and avoid problems down the road.

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