The tax treatment of a legal settlement can vary widely depending on the nature of the suit and the structure of the settlement. One recent personal injury case was settled for over $100K, and, after taxes and attorney fees, the recipient was able to retain less than 10% due to the structure of the settlement. Had the settlement agreement been structured differently the entire amount received, after attorney fees, could have been exempt from tax. The reason for this disappointing result is twofold; the differing treatment of certain types of proceeds, and the manner attorney fees are handled.
Legal settlement proceeds that constitute a return of capital, sometimes called make-whole payments, are not subject to tax. An example of a return of capital would be the funds received to replace a vehicle, or pay unreimbursed medical expenses, when struck by another driver. Legal settlement proceeds for physical pain and suffering are also exempt from tax by law. However, settlement proceeds for punitive measures, mental anguish, or lost income/wages, or for unspecified purposes are fully taxable. Likewise, settlement proceeds not to do something, such as giving up the right to sue or payments not to disclose information, are considered ordinary income and fully taxable. Making things worse, if non-taxable proceeds are lumped with taxable proceeds, the taxable proceeds taint the entire settlement as taxable. Some taxpayers have attempted to mitigate these results by structuring settlements as a sale of intangible rights to income in order to obtain the beneficial capital gains rates, but the courts have consistently ruled this improper and re-classed the income as ordinary.
The deductibility of attorney fees also bears consideration. Businesses that incur legal fees as part of their ordinary and necessary costs incurred in their normal course of business may deduct the expenses directly against their ordinary income. Individuals are not as fortunate. Individuals may only deduct legal fees incurred in defending income, and must deduct those as miscellaneous itemized deductions. Almost any settlement that results in taxable income can be considered in defense of income. However, as a miscellaneous itemized deduction, there may be little or no benefit. If the taxpayer doesn’t itemize deductions, the full deduction will not be realized. Likewise, if the taxpayer has not already exceeded the 2% threshold for miscellaneous itemized deductions, at least a portion will be lost. There is also the potential for further reduction if a taxpayer’s gross income exceeds certain thresholds. Finally, if the taxpayer is subject to alternative minimum tax after including the proceeds, the deduction will provide no benefit at all. Adding to the disparity, many states never allow miscellaneous itemized deductions, removing the deduction entirely.
As indicated above, there is a wide variety of tax treatment for proceeds and attorny fees depending on settlement structure and the taxpayer’s circumstances. In a worst case scenario, if attorney fees consist of a significant portion of the settlement, and no benefit is gained for their deduction, the recipient may end up with a cash loss after paying taxes on the proceeds. As such, it can be imperative to bring tax advice into negotiating a legal settlement.
If you are negotiating a settlement, or have question in regard to one, please feel free to contact us for a consultation.
Written by Damien Falato, CPA, MST, CGMA, Tax Director