Judgments, Settlements and IRS Tax Traps

When you're embroiled in a legal dispute, seeking restitution and hoping the judgment will swing in your favor, the last thing you're thinking about is the IRS. Depending on the outcome of your suit, though, any cash award you receive may end up causing future tax trouble if handled incorrectly. As you determine the best way to handle your case, including the terms of any legal assistance you're receiving, consider the potential of incurring a tax liability.

While it may seem counterintuitive to plan what to do with money you might receive, it's important to understand what your obligations will be to the IRS if things go your way. Planning ahead can prevent issues your attorney hasn't necessarily informed you of. Because tax commitments can be complicated by the details of your case, the resulting judgment and exactly how much you might be awarded, you have a lot to consider – beginning with your claim.

What's the Nature of Your Complaint?

The first question to ask is, "what am I seeking?" There's a vast difference in your tax requirements, depending on precisely what you're after. If, for instance, you're seeking compensation for a broken arm you sustained in a car accident, you generally will not be required to pay taxes on any award. On the other hand, if you're seeking missing or lost wages, the eventual payment will be taxable as income. Regardless of the case specifics, one important detail is that physical illness and injury awards are typically paid tax free, while those provided for psychological or emotional damage are usually taxable. There are exceptions to these guidelines, but a good rule of thumb is if the injury is physically visible, you're probably in the clear.

Tax Latitude for Medical Fees

If your suit yields payments to cover hospital visits or, say, physical therapy, you likely will not pay taxes on this. Even expenses for mental health counseling and therapy tend to be tax-free. These ground rules do not apply, however, if you're reimbursed in a judgment or settlement for medical costs you've already incurred. In that instance, you would likely be held liable to pay the corresponding taxes.

The Cost of Punitive Compensation

Unfortunately, any money you see from punitive damages will almost always be taxable. As an example, if you fall down a poorly lit stairwell, you may be awarded compensation for medical expenses as well as punitive payments. While the medical compensation will more than likely be non-taxable, the amount of your punitive damages will have to be included on your tax return.

Your Legal Expenses Can Cause Serious Problems

If your attorney is compensated on a contingent basis, meaning he or she gets paid from the proceeds won from your suit, you could be in for big trouble if you don't plan your taxes accordingly. Since the IRS doesn't deduct the cost you incurred from paying your attorney, you could be held responsible for the taxes on the entire amount. As an example, if you're awarded $50K for a taxable judgment and your lawyer is entitled to $15K of that money, you're held accountable for taxes on the $50K. There are, of course, exceptions to this, so make sure to do your research to check the facts against your specific situation.

Avoidable Liabilities

One thankfully simple detail to keep in mind is that the rules surrounding your tax responsibilities are typically the same whether you see a judgment or a settlement. Since there are so many intricate facets to tax liabilities resulting from legal outcomes, you'll want to make sure you have a long talk with a licensed tax professional before the case has concluded. If you're already facing a tax debt, said professional can help straighten out the issue and ensure you get compliant as quickly as possible.

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