It’s important to understand the tax consequences associated with receiving a legal settlement or award. A failure to pay attention to detail could result in a significant tax liability and other IRS tax problems.
Legal settlements may compensate a taxpayer for many different types of damages, including lost wages, medical bills, loss of enjoyment, loss of consortium, and emotional distress. Each category of damages may be treated differently for tax purposes.
Ideally, you should consult a tax attorney before accepting a legal settlement so you are aware of the tax ramifications. Your settlement may be allocated to different categories of damages, and these allocations could have a significant impact on your tax bill. However, the IRS doesn’t have to agree with your allocation if it doesn’t reflect the reality of the situation.
Origin of the Claim
The original of claim doctrine states that the tax treatment of an award is based on the original of the claim for damages. For example, wages are taxable, so a settlement for lost wages should be taxable.
On the other hand, compensation for medical bills is simply “making the victim whole”. The taxpayer does not receive any benefit from receiving recitation for their losses. Therefore, these amounts shouldn’t be considered taxable income.
A major exception to this rule is that compensation for damages related to physical injuries can be excluded from income. In the case mentioned above, even the lost wages would be excluded from income if they were caused by physical injuries.
Personal injury settlements may be related to physical injuries, emotional distress, or both. The key distinction is that if the physical injuries were the cause of the emotional distress, they will likewise be excluded from income. Otherwise, damages for emotional distress are generally considered income.
Punitive damages aren’t excluded from income, regardless of whether they are related to physical or non-physical damages.
Many personal injury attorneys are paid on a contingency basis. If their client receives a recovery, the attorney gets a percentage of the award.
Should the client be taxed on this amount, even though it may be paid directly to the attorney? The Supreme Court says yes.
Because a legal settlement may have a complex tax treatment, you should contact a tax attorney to determine the best way to allocate your damages or pay taxes owed on a legal settlement.
Get help with your IRS tax problems by calling The Gartzman Law Firm at (770) 939-7710. We can listen to your concerns and help you find the best tax resolution strategy for your case.