Anytime that there is potential for a cash settlement you should also prepare to consider the tax consequences. Litigation can be stressful and taxes are often the last thing on your mind. But there are a few important tips to keep in mind.
Type of Recovery and Why it Matters - You may recover money for physical injuries or for non-physical injuries such as lost wages, emotional or punitive damages. You may receive compensation for both types of injuries in a personal injury case. A civil rights case will generally not include compensation for physical injury. Generally, recoveries for physical harm are not taxable. Other types of monetary settlements are taxable.
Your Attorney’s Role - There are two potential areas where you will need to make choices:
May be possible to negotiate the taxable percentage of a settlement
If you have suffered both physical and non-physical injuries. Your attorney should ask you about your tax situation and take that into consideration.
In general, legal fees incurred in a lawsuit (that results in income) can be deducted.
Consult the Internal Revenue Services (IRS) website for more information on this deduction.
If the reward is large, the alternative minimum tax (AMT) may apply
The AMT is a section of the tax code most people do not generally need to consider. It was created to disallow certain deductions for people with high incomes. If you receive a very large sum as income, legal fees may not be deductible
The problem created by AMT and attorney fees
You may receive a lot less than you expect once the AMT and attorneys fees are deducted.
Tips for Consumers
- Make sure you talk to your attorney about tax consequences.
- Find out if your attorney is an expert in tax law.
- Consider hiring a tax attorney or tax specialist to review any potential settlement offer.