When Legal Awards Are Taxable
Lawsuit awards and settlements generally count as income for federal income tax purposes unless the payments are to compensate a taxpayer for personal injury or illness. These are free from federal income taxes.
The distinction between taxable and tax-free awards and settlements is the subject of frequent litigation between taxpayers and the IRS. A recent Tax Court case illustrates this point.
A taxpayer sued her former employer under civil rights statutes and the federal Americans with Disabilities Act. When the case was settled out of court for $100,000, the settlement agreement allocated $50,000 to wages and $50,000 to emotional distress.
The taxpayer received a Form W-2 for the $50,000 allocated to wages (from which federal income and employment taxes were withheld) and a Form 1099-MISC for the $50,000 allocated to emotional distress. She did not report any of the $100,000 as income on her federal income tax return. The IRS conducted an audit and she was hit with a bill for underpaid federal income tax.
The taxpayer took her case to the Tax Court where she argued that the settlement proceeds were for personal injury and thus tax-free. The Tax Court sided with the IRS by concluding that the settlement proceeds were clearly not paid as tax-free compensation for physical injury or illness, especially as the taxpayer received a Form W-2 and a Form 1099-MISC that together reported the entire $100,000 as taxable income.
In addition, the Tax Court agreed with the IRS that the taxpayer owed the 20 percent accuracy-related penalty on the underpaid tax bill since she had no reasonable basis for believing that the $100,000 was tax-free. (Mazie Green, TC Memo 2014-23)
Deducting Attorney’s Fees
You cannot deduct attorney”s fees incurred to collect a tax-free award or settlement for physical injury or sickness.
But suppose part of your award or settlement is tax-free (for physical injury or illness), and part is taxable (for interest or punitive damages). As a general rule, you must report the full amount of the taxable portion of the award or settlement as income on your return, without any reduction for the related attorney’s fees. Then you can treat the fees related to the taxable portion as a miscellaneous itemized deduction item on Schedule A of Form 1040.
Unfortunately, there are harsh limitations on miscellaneous itemized deductions. You can only write them off to the extent they exceed 2 percent of your adjusted gross income and they are completely disallowed for alternative minimum tax purposes. Therefore, your actual write-off for legal fees may be reduced to little or nothing.
There is one big exception to this rule, however. Attorney’s fees incurred in certain unlawful discrimination cases can be deducted without limitation. That way, you are not taxed on the money that goes to your attorney.
For purposes of this exception, unlawful discrimination is defined as violating any one of a whole list of laws that mostly have to do with civil rights, labor and employment rights, housing rights, disability rights and whistleblower rights.
Key Point: The issue of deducting attorney’s fees arises only in the context of an award or settlement that is at least partially taxable. Fees related to tax-free compensation for physical injury or illness are always nondeductible.
How the Rules Work
Payments you receive as compensation for physical injury or illness are free from federal income taxes whether or not they result from a court-ordered award or an out-of-court settlement or they are paid in lump sums or installments. Compensation for emotional distress arising from physical injury or illness is tax-free because the distress is considered part of the physical injury or illness.
You also don’t owe taxes on amounts received for medical expenses. However, if you deduct medical costs that are later reimbursed by an award or settlement, you must “recapture” any amount allocated to medical cost reimbursements up to the amount you deducted. When there is no specific allocation to medical costs you have deducted, a portion of the award or settlement is automatically considered to be a reimbursement for those costs.
If any part of your award or settlement is deemed to be interest for the period between the physical injury or sickness and the time you get paid, that part is taxable.
Oddly enough, amounts paid for lost wages are tax-free, even though the wages would have been taxable had you received them.
Example: Say you were seriously injured in a 2011 auto accident. You racked up $100,000 in medical expenses and $80,000 in lost wages. On your 2011 and 2012 federal income tax returns, you claimed medical expense deductions totaling $75,000 (you couldn’t deduct the full amount because of limitations on medical write-offs). In 2014, you received a $800,000 out-of-court settlement that covers medical expenses, lost wages, pain and suffering, and $35,000 for interest. Only $110,000 of the settlement is taxable ($75,000 for the deductions plus $35,000 interest). The remaining $690,000 ($800,000 minus $110,000) is tax-free.
Other Lawsuit Awards and Settlements
Payments for legal injuries are taxable. Legal injuries can result from such things as harassment, discrimination, wrongful termination, libel and invasion of privacy. The same is true for payments for emotional distress not caused by physical injury or sickness. Related payments for interest are also taxable.
Generally, payments for punitive damages (amounts paid for the particular purpose of punishing the wrongdoer) are taxable, even if they are paid as compensation for physical injury or illness. There is one exception: Tax-free treatment applies to punitive damages paid in civil wrongful death actions when applicable state law allows only punitive damages. Interest collected by plaintiffs on amounts paid for punitive damages is taxable — whether or not the related punitive damage award or settlement is taxable.
If you are involved in a lawsuit, seek professional tax advice to obtain the best possible tax treatment for any money you receive.
