This Daily Tax Tip Spotify Podcast and/or WordPress Blog Post understands that you are planning on filing a lawsuit from which you may derive a substantial amount of money. There are certain pitfalls of which you should be aware. The money you receive may be taxable and, in some cases, the attorney fees that you pay in relation to the lawsuit may not be deductible against the gross proceeds. Instead, the legal fees may be Nondeductible for years 2018 through 2025 due the temporary Repeal of Miscellaneous Itemized Deductions.
Special rules apply to attorney fees and court costs paid by, or on behalf of, a taxpayer in connection with any action involving a claim of unlawful discrimination, certain claims against the U.S. government, a private cause of action under the Medicare secondary payer rules, and Whistleblower Claims. Such fees and court costs are deductible in computing adjusted gross income on Form 1040. The Above the Line Deduction is allowed only to the extent of a taxpayer’s income from such actions and is not affected by the Nondeductibility Rules for years 2018 through 2025.
The Tax Treatment of Awards and Settlements can basically be divided into two distinct groups:
- Claims arising from a Physical Injury, and
- Claims arising from a Non-Physical Injury.
The Claims from each of these groups will usually fall into three categories:
- Actual Damages resulting from the physical or non-physical injury;
- Emotional distress damages arising from the actual physical or non-physical injury; and
- Punitive Damages.
Generally, settlements received as a result of Personal Physical Injuries or illness are excludible from income. However, settlements received on account of emotional and punitive damages are taxable. Damages received for lost wages, benefits, profits or other forms of business receipts are also generally taxable.
Often, a settlement may be allocated among Taxable Payments and Nontaxable Payments. If damages are clearly allocated to an identifiable claim in an adversarial proceeding by judge or jury, the IRS will usually not challenge their character (i.e., Taxable v Non-taxable) because of the impartial and objective nature of the determinations. However, many lawsuits are settled before a jury verdict. The IRS closely reviews such settlements and may challenge an allocation among the various claims where the facts and circumstances indicate that the allocation does not reflect the Economic Substance of the Settlement.
Effective Tax Planning can help reduce your potential tax burden if you are successful in your lawsuit. Please call me at your earliest convenience so we can discuss the particulars of your situation.
Please contact the office of Don Fitch Accountancy at (760)567-3110 or Email Don.Fitch@CPA.com if you have any questions or would like additional information.
DON FITCH, CPA
74478 Highway 111 #3
Palm Desert, CA 92260
Toll Free: (877)CPA-Help or (877)272-4357
P.S. My firm is based upon referrals. Please feel free to refer my firm to anyone you know that is looking for a new CPA and/or tax preparer. Thank you in advance.
(Updated 05242021-1 320-420)