This post summarizes the tax consequences that may stem from the resolution of a dispute, either through a settlement or a judgment.
The tax treatment of money or property received is the same regardless of whether the dispute is resolved through a judgment or a settlement. The specific tax treatment depends on the nature of the underlying claim. Certain types of claims result in an exclusion of the recovery from gross income, while others may allow for capital gain treatment. Amounts received for personal physical injuries or sickness under certain circumstances are generally excluded from gross income.
Tax Treatment of Settlements and Judgements
Generally, amounts received for nonpersonal injuries are included in gross income. Punitive damages are also generally included in gross income, with a limited exception for certain wrongful death actions.
However, Section 104(a) of the Internal Revenue Code (IRC) generally excludes amounts received as compensation for personal physical injury or physical sickness from gross income. This exclusion applies to a variety of payments, including those received under workmen’s compensation acts, certain accident or health insurance, pensions or annuities for injuries or sickness resulting from active military service, compensation for the death or disability of a public safety officer, disability income due to injuries from terrorist or military actions, and damages (other than punitive damages) received for personal physical injuries or physical sickness.
The most common and often disputed exclusion involves damages received for personal physical injuries or physical sickness. The key determination is whether the damages are received “on account of” the injury or sickness. This determination has been the subject of much litigation, with courts interpreting the phrase narrowly. For example, a settlement for legal malpractice related to a personal injury lawsuit may not qualify for the exclusion.
It’s important to note that this exclusion doesn’t apply to the extent the payments are attributable to medical expenses previously deducted. This prevents taxpayers from receiving a double tax benefit. Additionally, payments compensating for absence from work and calculated based on a percentage of the claimant’s pay are considered wage replacement and are not excluded. Each type of exclusion under Section 104(a) has its own nuances and specific requirements.
Tax Reporting of Settlements and Judgements
Similar to the tax treatment of settlements and judgements, the tax reporting requirements for settlements and judgements depend on the nature of the underlying claim. If the settlement represents wages, it must be reported on a Form W-2, with the employer withholding applicable taxes. This includes payments for back pay, front pay, bonuses, commissions, and other forms of remuneration for services performed.
However, if the settlement is for non-wage compensation, such as damages for emotional distress, it should be reported on Form 1099-MISC.
Deductibility Legal Fees
The IRC does not specifically list legal and other professional fees as deductible items. There is no provision dedicated to these types of expenses. Instead, the deductibility of legal fees in the context of settlements and judgements again depends on the nature of the underlying claim. For example, legal fees are generally not deductible if they are personal expenses. This includes fees related to divorce, child custody, and criminal defense.
If a taxpayer is engaged in a trade or business, legal fees and expenses incurred in prosecuting or defending against a suit having a business origin are typically deductible as trade or business expenses if all the applicable legal requirements for deductibility as trade or business expenses are satisfied.
When it specifically comes to legal fees from income-producing activities, certain fees may be deductible as miscellaneous itemized deductions. However, the Tax Cuts and Jobs Act (TCJA) suspended miscellaneous itemized deductions for tax years 2018- 2025. Therefore, these fees are currently not deductible unless they qualify under another provision, such as being considered a business expense.
For certain claims, the IRC allows an above-the-line deduction for amounts attributable to attorneys’ fees and costs incurred by individuals on account of claims of unlawful discrimination, as well as certain claims against the government, including claims brought under the False Claims Act.
Finally, note, legal fees may be partly deductible and partly nondeductible depending on the circumstances. For example, such expenditures may have been incurred partly for business and partly for personal reasons. In such a case, legal and professional fees must be allocated between the deductible and nondeductible categories.
The deduction rules are complex and require extensive analysis to determine whether a particular legal or professional expense is deductible. This section is not exhaustive of all the possibilities.
Conclusion
This memo is a general overview and only scratches the surface of issues that could have entire memos themselves. It is important to consult with your Topel Forman advisor to determine the specific tax consequences of your individual situation.
