Lawsuit Awards and Settlements: IRS Tax Law

With tax day fast approaching, Weitz & Luxenberg wants to ensure our clients have all the information they need to understand how to report their large settlements and lawsuit verdicts to the IRS. This information from the Internal Revenue Service does not consitute legal advice. We provide this document for informational purposes only. If you need help with your taxes, contact a tax attorney or an accountant. To file a personal injury lawsuit, click here.

1. Settlement proceeds are unreported.

2. All punitive damages are taxable whether received in relation to a physical or non-physical injury (caution: Alabama wrongful death cases).

3. Determine if any of the settlement proceeds are designated as interest, and if so, whether such interest is reported as income.

4. For out of court settlements, determine if the taxpayer reported correct allocations between taxable type awards, such as punitive, back wages, etc., and non-taxable amounts, such as emotional distress damages (caution: back pay may be excludable if received under circumstances described in Rev. Rul. 93-88, 1993-2 C.B. 61, obsoleted by Rev. Rul. 96-65, 1996-2 C.B. 6)

5. Verify that the taxpayer reported taxable amounts at gross rather than reporting them net of legal fees.

6. Allowable legal fees should be deducted on Schedule A as miscellaneous itemized deductions, unless the origin of the claim litigated is related to a Schedule C (independent contractor), or a capital transaction. This guide does not address the proper treatment of legal fees paid and deducted in taxable years prior to the year of recovery.

7. The legal fees deducted on Schedule A are a tax preference item for purposes of Alternative Minimum Tax (AMT).

8. For purposes of the AMT Credit, the legal fees which created AMT, are not allowed to generate the credit. They are "exclusion" items.

Issues for Lawsuit Proceeds Received After August 20, 1996

1. Lawsuit proceeds are unreported.

2. All punitive damages are taxable whether received in relation to a physical or non-physical injury (caution: Alabama wrongful death cases).

3. Determine if any of the settlement proceeds are designated as interest, and if so, such interest is reported as income.

4. Verify that amounts excluded from income were received in a case of physical injury. If it was not a physical injury, the only amounts excludable under IRC section 104(a)(2) are out of pocket costs for medical expenses incurred to treat emotional distress.

5. For out of court settlements for physical injury cases, determine if proper amounts were allocated between compensatory and punitive damages.

6. Verify the amount of out of pocket expense excluded for emotional distress in a non-physical injury case (that is, discrimination, fraud, etc.).

7. Verify that the taxpayer reported taxable amounts at gross rather than reporting them net of legal fees paid.

8. Allowable legal fees should be deducted on Schedule A as miscellaneous itemized deductions, unless the origin of the claim litigated is related to a Schedule C (independent contractor), or a capital transaction. This guide does not address the proper treatment of legal fees paid and deducted in taxable years prior to the year of recovery.

9. The legal fees deducted on Schedule A are a tax preference item for purposes of AMT.

10. For purposes of the AMT Credit, the legal fees which created AMT, are not allowed to generate the credit. They are "exclusion" items.

This comparison of issues before and after the 1996 law changes clearly reflects the fact that there is still much potential for adjustments in the area of lawsuit payments. By the time this guide is available service wide, a large portion of the examinations will probably be relating to post- August 20, 1996, payments. However, there may still be some pre-August 21, 1996, cases as well. For this reason, this guide provides assistance in examining the taxability of settlement payments received both on or prior and subsequent to, the amendment to IRC section 104 on August 20, 1996. (Note the exception to the effective date of this amendment).

For taxable years beginning after August 20, 1996, there will still be issues relating to allocations in out-of-court settlements. The allocation issues will be particularly important in out-of-court settlements for physical injury cases. Because many cases are settled to avoid the imposition of punitive damages, it is anticipated that the some taxpayers may erroneously allocate amounts between excludable and punitive damages in these cases. The allocation issue will not be as important in the non-physical cases because only out-of-pocket expenses for emotional distress are excludable under IRC section 104(a)(2) after August 20, 1996.

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see also:

App A: Sample IRS Tax Law: Lawsuit Awards and Settlements, how to report your compensation
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