People who receive money as a result of a legal settlement or judgment often wonder if the money received is taxable. Many are surprised to learn that the IRS typically requires individuals to pay taxes on legal settlements. The following facts may be helpful to those who have tax questions after finding themselves on the receiving end of a settlement.
The Same Rules Apply to Settlements and Judgments
Whether money is received after winning a case or settling outside of court, taxes are applied in the same manner in both instances. However, the IRS affords more flexibility for settlements. A taxpayer can influence the way in which a settlement is taxed depending on how the recovery is handled. In the event of an audit, the taxpayer would be required to supply a W-2, 1099, complaint, settlement agreement, and other pertinent documents.
No Tax on Personal Physical Injury Recoveries
According to Section 104 of the tax code, people who receive damages for suffering a personal physical injury are not required to pay taxes. The code was amended to exclude other personal damages such as emotional distress and defamation. However, the injury must now be visible. Current rules also exclude sexual harassment damages from tax-free status. Physical symptoms of emotional distress do not meet the “visible injury” requirement.
Medical Expenses are Not Taxed
Even in cases that do not involve physical injuries, according to IRS rules, payments for related medical expenses are tax-free. Surprisingly, medical expenses may include visits to a mental health professional, chiropractor, physician, or physical therapist. Many nontraditional treatments are also included.
Plaintiffs May Pay Unexpected Tax on Legal Fees
Even if the defendant pays the plaintiff’s attorney’s contingent fee, the IRS will generally treat the plaintiff as if he or she has received his or her full recovery along with the attorney’s fee. Therefore, plaintiffs should consider legal fees when planning tax payments. Plaintiffs are not required to pay taxes on legal fees in cases that involve a personal physical injury.
Tax planning can be especially stressful for individuals who have are recovering from a personal injury. Most people are unaware of the complex rules that determine whether taxpayers are required to pay taxes on legal settlements. Gary M. Kaplan is qualified to assist individuals in Maryland, Washington, D.C., Florida, New York, and Utah who are facing important tax considerations following recovery of a judgment or settlement amount. To receive a free consultation, call 1-866-643-3560.
