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The Taxation of Legal Settlements and Deductibility of Legal Fees

Article Highlights:

  • Taxation of Legal Settlements
    o   Wrongful Death
    o   Emotional Distress
    o   Previously Deducted Medical Expenses
    o   Employment Discrimination
    o   Age Discrimination
    o   Punitive Damages

  • Deductibility of Legal Fees
    o   Personal
    o   Business
    o   Allocations

  • Supreme Court Ruling on Contingent Attorney Fees

Navigating the taxation landscape of legal settlements and the deductibility of associated legal fees can be a complex endeavor. The Internal Revenue Service (IRS) has specific rules that govern how these financial transactions are treated for tax purposes. Understanding these rules is crucial for individuals and businesses alike to ensure compliance and optimize their tax positions.

Taxation of Legal Settlements - Legal settlements can arise from a variety of circumstances, including employment disputes, personal injury claims, and class action lawsuits. The tax treatment of these settlements depends largely on the nature of the claim.

Generally, settlements that compensate for physical injuries or sickness are not taxable, and you do not have to include the settlement proceeds in your income. However, punitive damages and interest on the settlement are taxable, regardless of the nature of the claim.

For non-physical injury settlements, the settlement amount is typically considered taxable income. The rationale is that these settlements replace income that would have been taxable if received in the normal course, such as salary or business income.

The following is the tax treatment for a variety of circumstances:

  • Wrongful Death – Wrongful death is considered physical injury or physical sickness for purposes of the income exclusion. In addition, punitive damages are excludable where state law provides that only punitive damages can be awarded in wrongful death suits.

  • Emotional Distress - Emotional distress isn’t considered physical injury or physical sickness for purposes of the income exclusion. However, the exclusion from gross income does apply to the portion of a damage award received for emotional distress that is attributable to a physical injury, but not in excess of the amount paid for medical care related to emotional distress.

  • Previously Deducted Medical Expenses – Even though awards for physical injury or physical sickness are excludable, if any part of the award received is compensation for medical expenses deducted in a prior year, that portion of the award must be included as income, up to the amount of the deduction taken.

  • Employment Discrimination - No exclusion is allowed for damages received in a suit involving employment discrimination or an injury to reputation that is accompanied by a claim of emotional distress. However, the exclusion would apply to a claim of emotional distress related to a physical injury or physical sickness.

  • Age Discrimination - The law doesn’t consider back pay or liquidated damages received under the Age Discrimination in Employment Act (ADEA) to be compensation for personal injuries; therefore, these payments are includable in income. But see the special treatment of attorney fees below.

  • Punitive Damages – Punitive damages are made as a punishment for unlawful conduct and are always taxable; they cannot be excluded from income as damages received due to personal physical injury or physical sickness, except as noted above for wrongful death.

  • Unpaid or Disputed Employment Earnings – Back pay, severance pay, overtime pay, etc., are all treated as W-2 type income and are both taxable and subject to payroll FICA withholding.

  • Interest – Interest that may be included in an award, even one for personal injury or sickness, is not excludable and must be included in gross income.

It’s not unusual for a plaintiff to sue for both excludable and non-excludable damages. 

Example: an employee is injured on the job and sues for back vacation pay of $10,000 and damages for personal injury in the amount of $90,000 (a total of $100,000). If the suit is settled for $50,000 without a stipulation of how the settlement is applied, the settlement will need to be allocated in the same manner as the original suit. In this example, the settlement would be allocated $5,000 for back vacation pay (taxable) and $45,000 for personal injury (excludable). 

Deductibility of Legal Fees - The deductibility of legal fees associated with obtaining a legal settlement is equally nuanced. The IRS distinguishes between personal and business legal expenses, with different rules applying to each category.

  • Personal - Personal legal expenses, such as those incurred in a personal injury lawsuit, had been allowed as part of miscellaneous itemized deductions, and subject to a 2% of adjusted gross income (AGI) reduction, until the Tax Cuts and Jobs Act (TCJA) of 2017 suspended miscellaneous itemized deductions through 2025. This means that, for the time being, individuals cannot deduct legal fees related to personal claims on their tax returns.

    o    Exceptions - However, as with many tax issues, there are exceptions. Legal fees related to certain types of claims, such as unlawful discrimination and whistleblower awards, are deductible above the line, meaning they can be deducted from gross income to arrive at AGI, and aren’t subject to the TCJA restriction on miscellaneous itemized deductions. This is beneficial because it reduces the taxpayer's AGI, potentially qualifying them for other tax benefits.

  • Business - For business legal expenses, the rules are more favorable. Legal fees incurred while conducting business are generally deductible as business expenses. This includes legal fees to defend or protect your business, collect income, or acquire business assets. These expenses are deducted on Schedule C for sole proprietors or on the appropriate business tax return for other business entities.

  • Allocating Legal Expenses - When legal expenses are incurred for multiple purposes, such as both personal and business matters, the IRS requires an allocation of the expenses. Only the portion of the legal fees related to the business or income-producing activity is deductible.

    Example: Where a lawsuit involves both a claim for personal injury (a personal expense) and a claim for lost income (a business or income-related expense), only the legal fees attributable to the lost income claim would be potentially deductible.

The method of allocation can vary. It may be based on the time spent on each issue, the value of the claims, or other reasonable methods. The key is that the allocation must be reasonable and substantiated.

Supreme Court Ruling on Contingent Attorney Fees - A significant development in the taxation of legal settlements is the Supreme Court's ruling in Commissioner v. Banks. The Court held that contingent fees paid to an attorney out of a taxable damage award or settlement are includible in the plaintiff’s (attorney’s client’s) gross income. This means that even if a portion of the settlement is paid directly to the attorney as a contingent fee, the full amount of the settlement is considered taxable income to the client. Thus, the plaintiff is unable to deduct the attorney fees as a miscellaneous itemized deduction, for tax years 2018-2025.

The taxation of legal settlements and the deductibility of associated legal fees present a complex set of rules that taxpayers must navigate. While certain types of settlements are exempt from taxation, and some legal fees are deductible, the specifics depend on the nature of the claim and the purpose of the legal expenses.

So, before you rush out and spend any of the money you may receive as a legal settlement, you had better contact this office and see what the government’s share is, because it could be substantial. In addition, with some careful analysis, it may be possible to take actions that will reduce the tax.

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