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 and settlement, the government may take a percentage. 

Before you spend all the lawsuit money, you need to set aside enough to pay out any potential taxes at the end of the year that you may owe. It's important to know when taxes are due to avoid penalties. It's also essential to understand the implications of not paying taxes, as there are serious consequences, such as going to jail for not paying taxes. Let’s look at lawsuits and taxes and ways to decrease your tax burden in this article.

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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 dried, so always speak with a professional to determine how your lawsuit is laid out and how the damages are allocated. 

The tax of a lawsuit 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:

1. Recovery of wages - taxed as wages
2. Negligent emotional distress - taxed
3. Damages to a structure - probably not taxed
4. Physical injuries or physical sickness - probably not taxed
5. Intentional infliction of emotional distress - taxed
6. Punitive (punishes the defendant) damages - taxed
7. Employment discrimination - taxed
8. Copyright infringement - taxed
9. Pre-judgment or post-judgment interest - taxed
10. 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. This document can help you avoid paying taxes on the entire amount that you may win. Try to have the lawsuit settlement 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

There are some tax advantages to settling your lawsuit out of court. Any prejudgment or post-judgment interest on the award is taxable, even if the award was not taxable. In addition, you may or may not get more money from going to court. 

Hopefully, you have picked an experienced attorney who can guide you through the legal settlement versus court choices.

How Much is Taxed?

Once you win a lawsuit, the legal firm representing you takes a portion. This portion usually ranges between 33% (for settlement) and 40% (for going to court). Let’s say you win a lawsuit for $100,000. 

The lawyers will take their $33,000 if you settled, or $40,000, if you went to court before they pass the check on to you. If the award was taxable, you generally do not pay taxes on the remaining $67,000 or $60,000. Instead, you get to pay taxes on the entire $100,000. 

In the past, you could deduct legal fees. In 2004, Congress decided that only legal fees on employment claims and some whistleblower claims could be deducted. This has been fiddled within Congress, so could you check with a qualified CPA for more information on deductions?

How much you pay in taxes depends on your tax bracket. Again, a CPA or qualified tax professional can help advise you.

How Are Lawsuit Settlements Paid?

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

1. 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. 
2. Once the forms are signed, the check is released by the insurance company 
3. The legal representative will pay off any liens against the plaintiff (you), such as medical expenses
4. The legal representative then pays off any legal fees or court costs
5. The plaintiff (you) gets whatever is left
6. At the end of the tax year, you get a 1099 and must file taxes including your lawsuit settlement or judgment

Depending on how your settlement was allocated, there may not be a great deal left over. Keep in mind what the money is for. If you have long-term medical expenses, for instance, you are paralyzed, this money needs to be used to support you and pay for your medical treatment. 

Buying new cars for all your relatives or an in-home theater system is probably not the best use of the money. Here again, a qualified investment advisor can help you make the most of this money.

Lump Sum or Structured Lawsuit Settlement

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 full. These companies offer a lump sum for all or some of the settlement amount. Approach these with great caution.  You may end up with a tax burden or other issues that evaporate the money. Do you research before you decide to sell your structured settlement?

Before you decide between a lump sum and a structured settlement, speak with a qualified tax advisor and financial advisor. Getting information before you choose can make a difference in your life.

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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