How to avoid paying taxes on a lawsuit settlement

how to avoid paying taxes on a lawsuit settlement

Winning or settling your lawsuit can be exciting. After you receive the settlement money and pay the attorney fees, most people assume that the rest is theirs to keep. However, some settlements are subject to taxes. And, unfortunately, many people don’t realize this until tax time the following year, after much of the money has been spent. To avoid a nasty, unexpected tax bill, this article will show you how to reduce or eliminate the chance of having to pay taxes on a lawsuit settlement. If you suddenly end up with a large sum of money, work with a financial advisor to make the most of your windfall.

Factors Affecting a Lawsuit Settlement

how to avoid paying taxes on a lawsuit settlement

how to avoid paying taxes on a lawsuit settlement

Under Section 61 of the Internal Revenue Code, all payments from any source are considered gross income unless there is a specific exception. When you win a settlement, it can be difficult to know whether or not your award is taxable without going into the details. This list highlights some of the common factors that determine taxation:

  • Physical injury or illness: Personal injury or illness settlements where you have proven “appreciable physical injury” are not considered taxable by the IRS.

  • Emotional distress can be taxing: You will owe taxes on emotional distress awards unless the distress was caused by the injury or illness caused by the accident.

  • Medical expenses: Awards for medical expenses are not taxable as long as you have not deducted the related medical bills on the previous year’s taxes. If you took them out last year, then you’ll pay taxes on that amount this year under the IRS’s “tax benefit rule.”

  • Punitive damages are taxable: Some judgments and settlements include an award of punitive damages against the defendant. These damages can provide significant compensation to the claimant. The entire punitive damages award is taxable, which can result in high taxes.

  • Contingency fees may be taxable: If your settlement is not taxable, the legal fees will not affect your taxable income. Accident and personal injury cases such as slip and fall or worker’s compensation are excluded. However, for taxable settlements, you may owe taxes on the full settlement, even when the defendant pays your attorney directly.

  • Negotiate the amount of 1099 income before finalizing the settlement: Before you sign the settlement agreement, determine whether or not the defendant will issue a Form 1099 or not. If they intend to issue one, negotiate the 1099 income to be a lower number than your actual settlement amount.

  • Allocation of losses to reduce taxes: During settlement negotiations, you can negotiate to allocate a larger portion of the settlement to non-taxable prize categories. For example, increase the award related to bodily injury and illness and decrease the amounts related to emotional distress.

  • Capital gains instead of ordinary income: Depending on the nature of your claim, you may be able to treat a portion of your settlement as goodwill. If you have been sued for plant damage to your home or business, you may be able to classify the settlement as goodwill. Alternatively, your settlement may qualify for a tax basis recovery, which is not counted as income.

  • Spread payments over time to avoid higher taxes: Getting a large taxable settlement can increase your income in higher tax brackets. By spreading your settlement payments over several years, you can reduce the income subject to higher tax rates.


how to avoid paying taxes on a lawsuit settlement

how to avoid paying taxes on a lawsuit settlement

When you receive a settlement, there are many factors related to the litigation itself as well as the state you are in that determine whether you will owe taxes on that amount. Because there are so many nuances, we recommend that you speak with an attorney and tax professional to determine which rules apply to your particular situation. When you talk to these professionals, you may learn how to avoid paying taxes on a settlement and keep more of the money for yourself.

Advice on taxes

  • Getting a settlement can be life-changing and a solid step toward dealing with a bad situation. This money can set you up financially for life if you can invest it wisely. A financial advisor can help you create a plan to grow your money wisely to meet your needs and goals. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three financial advisors serving your area, and you can interview your advisors at no cost to decide who is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

  • Paying taxes is an obligation for every investor, whether you invest full-time or as a supplement to your salary. However, it can be a challenge to predict what those taxes will be. Our income tax calculator helps you calculate the taxes you owe based on your income, location, filing status and basic deductions.

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