How and when you receive your settlement claim can have a big impact on the amount of taxes you will owe the Internal Revenue Service and the State of California. In this article, we will discuss some of the consequences and potential ways to limit your tax liability once you receive your settlement of judgment.
The Law Offices of Edward Misleh, APC is a Sacramento law firm, located in Sacramento, California that practices personal injury law. We represent clients in Sacramento, California and clients in Northern California with services they need and deserve when addressing injuries suffered from an auto accident or slip and fall due to another party’s negligence. Call now our Lawyer Hotline. We offer a free consultation and no upfront fees. We get paid only when we settle your case. Call now 916-443-1267 for your free consultation.
Personal Injury Claim Tax
Your personal injury claim tax can be substantial, but there are steps you can take to reduce any potential tax liability.
Tax on Settlements and Judgments
You will have more options to reduce personal injury claim tax liability if a case settles rather than goes to judgment. You can influence how your recovery is taxed by how you deal with these issues.
Taxes Depend on the “Origin of the Claim.”
Your personal injury claim tax is determined on settlements and judgments according to the item for which the plaintiff was seeking recovery. If you get laid off at work and sue your employer for discrimination seeking wages and severance, you’ll be taxed as receiving wages. In fact, your former employer will probably withhold income and employment taxes on all (or part of) your settlement even if you no longer work there. But if you sue for damage to your condominium by a negligent building contractor, your recovery will not be taxed as income but will be treated as a reduction in your purchase price of the condominium.
Personal Physical Injuries and Physical Sickness is Tax Free
If you sue for personal physical injuries like a slip and fall or car accident, your damages are tax-free. However, to avoid any tax, your injury must be “physical.” Neither the IRS nor Congress has made clear what that means, but the IRS will require that your injuries be visible to be “physical.” This “observable bodily harm” standard generally means that if you sue for intentional infliction of emotional distress or for sexual harassment, your recovery is taxed.
Medical Expenses are Tax Free
Even if your injuries are purely emotional, payments for medical expenses are tax-free, and what constitutes “medical expenses” is surprisingly liberal. For example, payments to a psychiatrist or counselor qualify, as do payments to a chiropractor or physical therapist. Many nontraditional treatments count too.
Allocating Damages Can Save Taxes
Most legal disputes involve multiple issues and you may be able to enter into an agreement about what is being paid which can benefits both you and the other party. It is almost always best for plaintiff and defendant to try to agree on what is being paid and its tax treatment. Such agreements aren’t binding on the IRS or the courts in later tax disputes, but they are rarely ignored. In fact, as a practical matter, what the parties put down in the agreement is often followed. If you’re settling an employment suit, you could allocate payments for wages (which require withholding of taxes and a W-2 form); emotional distress damages (non-wage tax reported on a 1099 form); reimbursed business expenses (nontaxable, unless previously deducted); and pension or fringe benefit payments (usually nontaxable).
You May Have Capital Gains Instead of Ordinary Income
Outside the realm of suits for accidents or injuries, just about everything is income. However, that doesn’t answer the question of how it’s taxed. If your suit is about damage to your house or your factory, the resulting settlement may be treated as capital gain, taxed at a current top rate of 15% instead of 35%. Even better, depending on your tax “basis” (basically, your original purchase price, increased by any improvements you’ve made, and decreased by depreciation, if any), your settlement may be treated as a recovery of basis, not income.
Your Tax Liability on Attorney Fees
If you are the plaintiff and have entered into a contingency fee agreement with your attorney, you will be taxed on the entire settlement amount, even if the defendant pays your lawyer directly his percentage.
Punitive Damages and Interest are Taxed
If you are injured in a car crash, damages your receive as compensation is tax free but, any payment you receive as punitive damages and any pre-judgment or post-judgment interest you receive is taxed.
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