Settlements and judgments are both taxable, but there may some exceptions if you settle.
Settlements and judgments are taxed pursuant to the type of claim involved. For example, lost wages that are recovered will be taxable as wages; lost business profits will be taxable as business profits; etc. With respect to losses in the value of a property, there could be capital gains or losses.
You may have heard that personal injury damages are not taxable, and for the most part this is true.
Personal injury damages are not taxable, but the injury must be visible and physical. Emotional injuries settlements that do not originate from a physical injury are not deductible, but they may be reduced by certain payments for medical expenses.
Settlements payments for medical expenses are tax-free. Punitive damages and interest are never tax-free.
Amounts allocated to attorneys’ fees are still taxable to you unless your settlement payment itself is completely non-taxable. However, in certain employment discrimination cases, attorneys’ fees can be deducted. Attorneys’ fees awarded in the following types of cases can be deducted on Schedule A of the recipient: the Civil Rights Act of 1991, the National Labor Relations Act, the Fair Labor Standards Act, the Age Discrimination in Employment Act, the Rehabilitation Act of 1973, the Employee Retirement Income Security Act, the Employee Polygraph Protection Act of 1988, the Worker Adjustment and Retraining Notification Act, the Family and Medical Leave Act, Title VII, the Uniformed Services Employment and Reemployment Rights Act, the Americans With Disabilities Act, federal whistleblower statutes, and any state or local equivalents of the aforementioned laws.
BUT BE WARNED, under the new tax law, recoveries from sexual harassment cases where there is a non-disclosure agreement in place, will not be able to be deducted by the payor or the payee. Congress likely intended for this to only affect the payor/defendant, but it affects the payee/plaintiff as well. Hopefully, this is remedied in the future.
Attorneys’ fees that can be classified as a business expense remain deductible.
Because the laws around the taxability of settlements are so complex, it is essential to have a tax lawyer consult with the attorneys who are drafting the settlement.
It is important to make sure your tax lawyer allocates settlement payments true to form and in the way most beneficial to you.
It is also important in employment cases that a tax lawyer advise the employer making the payment of any withholding requirements to avoid possible penalties.
Mendes Weed, LLP is experienced in providing tax consulting services to attorneys who are in the process of drafting and preparing a settlement agreement. It is definitely worth the additional time and expense to have a tax lawyer review your agreement to make sure you end up with an unanticipated tax bill.
Mendes Weed, LLP is here to help you if you have any questions. (925) 390-3222.