Attorney David I. Fuchs
Mar. 27, 2018
A legal settlement can throw you for a loop when it comes time to do your taxes. Months ago, you received a check to cover your accident-related losses, including lost wages and medical bills. Now that tax time is here, do you owe the Internal Revenue Service (IRS) a chunk of what you won in a settlement? Whether or not your settlement is tax-free actually depends on the type of damages and how the IRS views them. Here are six things to know about settlements and taxes in Florida.
It will please accident victims to know that the IRS does not tax the amount of money you receive as compensation for physical injuries or illnesses. Damages you receive as reimbursement for your (as Section 104 of the federal tax code puts it) “observable bodily harm” are not taxable. Note that your injuries must be physical and visible in nature to be exempt from taxation.
Emotional distress and mental anguish generally fall into the taxable bracket as “income” according to the IRS, especially if the defendant issues an IRS Form 1099 for the settlement. Since emotional, mental, and psychological harms aren’t physical or visible, the IRS will generally deem them taxable types of income. There is a chance a plaintiff could fight this if the IRS taxes physical damages that result from emotional harm, such as a stress-induced ulcer. However, going up against the IRS can be difficult if the defendant gave you 1099.
Medical bill compensation awards also pass under the IRS’s radar as nontaxable payments. The amount you receive to compensate you for your past and future accident-related medical costs are not part of your revenue for the year and therefore are not subject to taxation. No matter how much you earned in medical bill reimbursement, the IRS won’t tax it in most circumstances.
Most payments for lost wages will face taxation. The IRS taxes lost wage payments because generally, the plaintiff recovers for full, gross lost wages, not after-tax wages. Therefore, to the IRS, you still need to pay taxes on this earned income. Most settlements for missed wages or lost profits will incur taxes.
Be cautious of how the IRS will tax your settlement. If you paid your attorney on a contingency-fee basis, meaning you paid him or her out of the settlement you won, the IRS will include the attorney’s share as part of the settlement you earned. You will, therefore, have to pay taxes on the full amount of the settlement, prior to what you give your attorney. In other words, if you win $100,000 in a settlement but give your attorney $33,330, the IRS will tax the $100,000, not the $66,670 you kept.
There is a chance you could save on settlement taxes by allocating your damages. Most settlements will include several different types of damages, some taxed and some not. The plaintiff’s best interests often involve working with the defendant prior to reaching a settlement to agree upon taxation issues. There may be room to negotiate a different type of settlement award to help both sides on taxes. While an agreement between defendant and plaintiff won’t bind the IRS to act a certain way, it could help you save money.