Introduction
Navigating the complex world of settlement taxation can be challenging, and numerous pitfalls can catch recipients off guard. This blog post highlights some of the most common mistakes people make when dealing with the taxation of settlements and guides avoiding these errors with pre-planning and learning what legal settlements are taxable and how to minimize taxation of settlement awards.
- Assuming All Settlement Money is Tax-Free
The Pitfall:
One of the most common misconceptions is that all settlement money is tax-free. This assumption can lead to serious tax problems down the line.
How to Avoid It:
- Understand that the taxability of a settlement depends on the nature of the claim and the types of damages awarded.
- Consult a tax professional to determine which portions of your settlement may be taxable.
- Don’t spend all your settlement money without setting aside funds for potential tax liabilities.
- Misunderstanding the “Physical” in Physical Injury
The Pitfall:
The IRS allows an exclusion from taxable income for settlements related to physical injuries or physical sickness. However, many people misinterpret what qualifies as “physical.”
How to Avoid It:
- Understand that emotional distress alone doesn’t qualify for the physical injury exclusion.
- Ensure your settlement agreement clearly defines any physical injuries or sickness.
- If your emotional distress led to physical symptoms (e.g., ulcers, headaches), document these thoroughly as they may qualify for the exclusion.
- Ignoring State Taxes
The Pitfall:
While focusing on federal taxes, many settlement recipients forget about state taxes, which can also apply to settlements.
How to Avoid It:
- Research your state’s laws regarding settlement taxation.
- Consider consulting with a local tax professional who understands both federal and state tax implications.
- Factor in potential state tax liabilities when budgeting your settlement funds.
- Overlooking the Tax Impact of Attorney Fees
The Pitfall:
Many assume they only pay taxes on the portion of the settlement they receive after deducting attorney fees. However, in many cases, due to Commissioner v. Banks, 543 U.S. 426, and Commissioner v. Banaitis, the total settlement amount, including the portion paid to attorneys, is considered taxable income.
How to Avoid It:
- Understand how attorney fees are treated for tax purposes in your type of case.
- Utilize the Plaintiff Recovery Trust before finalizing the settlement to avoid taxation of the attorney fee portion of the settlement.
- In some cases, such as employment claims, attorney fees may be deductible “above the line,” reducing your taxable income.
- Factor in the tax impact of attorney fees when negotiating your settlement.
- Failing to Properly Allocate Damages in the Settlement Agreement
The Pitfall:
A poorly drafted settlement agreement that doesn’t clearly allocate damages can lead to unfavorable tax treatment.
How to Avoid It:
- Work with your attorney to ensure the settlement agreement clearly allocates damages to specific claims.
- Understand the tax implications of different types of damages and push for an allocation that maximizes tax efficiency while accurately reflecting the nature of your claims.
- Have a tax professional review the settlement agreement before signing.
- Not Planning for Estimated Tax Payments
The Pitfall:
If a significant portion of your settlement is taxable, you may need to make estimated tax payments to avoid penalties.
How to Avoid It:
- Consult with a tax professional to determine if you need to make estimated tax payments.
- Set aside funds for these payments as soon as you receive your settlement.
- Mark your calendar with estimated tax payment due dates to ensure you don’t miss them.
- Mishandling Structured Settlements
The Pitfall:
Structured settlements can offer tax advantages, but mishandling them can negate these benefits.
How to Avoid It:
- Understand the terms of your structured settlement thoroughly before agreeing to it.
- Once a structured settlement is set up, avoid trying to sell or alter it, as this can have adverse tax consequences.
Conclusion
Understanding the taxation resulting from different types of damages is essential for everyone involved in a legal settlement. This guide is only general information. Tax law is complex and can vary based on the specific facts of your case. Please seek the advice of a qualified taxation expert / attorney to understand the tax consequences of your settlement.
Proper planning and understanding can assist in avoiding unexpected tax liabilities and maximizing your settlement proceeds. Learn more on how to reduce taxation on lawsuit settlements or avoid paying taxes on settlement money.
