Taxes on Legal Settlements: 7 Important Things You Should Know
For a vast majority of personal injury clients, your award for injuries will be tax-free.
It is important to consult with an experienced tax expert and discuss the following points on your Legal Settlement:
1. Taxes are the same regardless of whether it’s settlement or judgment.
The rules of taxation are similar whether or not you settle or obtain a judgment in your favor. The one benefit of settling cases is there is some, but only slight, flexibility in qualifying what components the settlement consists of. For example, qualifying a settlement for recovery of punitive damages, lost wages or past medical expenses can have an impact on how your settlement is taxed. Since your lawyer will draft your settlement agreement, there is some flexibility. On the flip side, a judgment is very clear as to how the award is qualified based upon the jury verdict form.
2. Taxes are directly related to the claim’s origins.
Legal recovery is generally taxed depending on the nature or the origin of the claim. For instance, if it’s business-related or perhaps wage-related, then you can expect that these will be treated as ordinary income; hence, you will be taxed as such. If the claim is related to damage to property by a negligent contractor or developer, the legal recovery can be regarded as a reduction in the price of your property. It will not be treated as ordinary income.
3. Legal recoveries for personal physical sickness or physical injuries are free of tax.
Prior to 1996, all cases of personal damages including defamation and emotional distress were free of tax. However, all ‘personal’ injuries or sickness should be classified as ‘physical’ in order for it to be considered as tax-free. What this essentially means is that you need to have a clearly visible physical injury or sickness that is the direct result of the incident. Collecting settlement for emotional distress or even sexual harassment will not free you from taxes.
4. Medical expenses are free of tax.
All medical expenses, regardless of whether the treatment is for a physical injury or sickness or an emotional or psychological one, are completely free of tax. As such, you can always seek psychiatric mental health counseling and you will not be taxed for that. Also included are non-traditional healthcare treatments, physical therapy, and chiropractic treatments, among others.
5. Manifestations of emotional distress are not considered ‘physical’ evidence of sickness or injury.
Emotional distress often presents physical symptoms such as stomach aches, body aches, and headaches. For instance, it is known that individuals who are emotionally upset are also predisposed to the development of gastritis or ulcers. While ulcers are ‘physical’ manifestations, they are not the source of the claim. Ulcers developed because of emotional distress and not the other way around. As such, you can expect to be taxed.
6. Punitive damages, as well as interest, will always be taxable.
In certain cases where there are both compensatory and punitive damages, know that the compensatory damage is tax-free if there is physical sickness or injuries. However, punitive damages will always be meted with a tax. The same is true with pre-judgment or even post-judgment interest. These are also taxable. It is for this reason that it is often more attractive to go for a settlement rather than pursue the case in court and obtain a judgment.
7. Attorney fees can be very tricky but are simple for injury claimants.
For tax purposes, the entire amount of the settlement is considered income regardless of attorney fees. Attorney fees are then deducted after the fact which is subject to many limitations. However, since most injury claims are non-taxable, the attorney fee complexities are usually a non-issue. If you received compensation for punitive damages, then that income will be taxable and you will have to allocate which portion of the attorney fees are allocated to the punitive damage recovery.
For consultation on your personal injury case, contact us at Aronberg, Aronberg, and Green today!