Along with a new year comes the anguish of another tax cycle. No one wants to pay taxes on money he or she has worked hard to earn. To find out that some percent of money awarded with a jury verdict or through a negotiated settlement could be taxed, is insult to injury. However, the IRS does not see it that way.
To determine if a verdict award or settlement is subject to tax depends on how it is described and allocated. Regardless of the source, if the money is intended to make the victim whole, it is non-taxable. If, on the other hand, the money is a replacement for income, then it is taxable. That is the simple answer, but nothing involving the IRS is ever simple.
What is Taxable?
According to the IRS, any verdict award or settlement that is defined, as “compensation” for economic loss is taxable. For example, lost wages are taxable, unless an injury caused the loss. Any compensation for a non-physical injury is taxable. For example, money awarded for emotional distress or negligence would be subject to taxation. In addition, any award that is defined as punitive damages is taxable under IRC section 104(a) (2).
What Does The IRS Look At When Making Tax Determinations?
- If any taxable lawsuit, award, or settlement are unreported.
- How the money was allocated between compensatory, and punitive damages. This is very important in and out of court settlements to make sure the settlement is properly split between what is taxable and what is non-taxable. It’s also important because, in addition to the non-taxable portion, there is also no tax penalty for expenses the victim paid, which could include attorney’s fees.
- All punitive damages are taxable.
- What percent of the verdict award or settlement is assigned to interest, if any. Interest must be reported as income to the IRS.
- Damages for emotional stress caused by the injury are non-taxable. However, any costs associated with the emotional stress, (counseling, medications, etc,) are taxable if it was claimed as a medical expense on the previous year’s taxes.
- If legal were deducted properly, they should be on Schedule A as a miscellaneous itemized deduction.
What is Compensatory?
Compensatory is the intended payment to compensate a person for actual loss they have suffered; these losses tend to be economic losses. To confuse the issue even more, the IRS has to make a determination if the loss is taxable or not. Under tort law, compensation can be for personal injuries or a breach of contract. The portion of the compensatory damages that is taxable depends on a host of variables.
In the case of compensation for lost wages, this is taxable. Why? Because the IRS views this income as a replacement for money that should have been earned on the job, and therefore would have been taxed as income.
Pain and suffering are complicated because the IRS knows that some percent of that money was “earned,” by the pain, think of it as “sweat equity.” Pain and suffering are different from emotional distress. Pain and suffering compensation is not taxable, but emotional distress composition is taxable. The IRS links pain and suffering to the actual injury. Suffering is viewed differently from pain, is it actually more of a personal sacrifice the victim has to make due to the injury. For example, a parent who cannot ride a bike with their children, due to an injury is suffering from the inability to enjoy that activity. However, pain and suffering are always linked together under the law, so the IRS does not separate them either.
Emotional distress, depression, or anxiety, even though they involve suffering as well, are seen differently by the IRS, and this variety of suffering is taxable. However, the medical expenses associated with emotional distress, are not taxable, and are applied the same as other medical expenses the victim has incurred.
Compensation for property damage is generally non-taxable. If, for example, the injury was a result of a car accident and the car was repaired. The money to repair the car is non-taxable.
What is Punitive Damage?
Punitive damages are generally added to compensatory damages where the defendant acted with malice, recklessness, or deceitfulness. In general, punitive damages are taxable. That money should be reported as “Other Income” on the income tax form, either 1040 or 1040ES. This is the easiest IRS landmine to figure out. Punitive damages, even though they originate from the injury under the law, are actually caused by the action or inaction of the defendant. Punitive damages are designed to punish the defendant, and therefore they are considered income under the tax code, which makes that money taxable.
Structured settlements can consist of both taxable and non-taxable money, as they are a combination of compensatory and punitive damages. They are allocated by a third party, which makes the actual transition tax-neutral.
Under a structured settlement, all future payments, after an initial lump sum, are tax free, including:
- Federal and state income taxes
- Taxes on interest, dividends, and capital gains
- The Alternative Minimum Tax (AMT)
The plaintiff can take the remainder of the money, including interest, with no additional tax ramifications, as long as the structured settlement is set up properly. Even though structured settlements tend to be smaller than lump sum settlements, they can be advantageous due to their tax-free status.
Structured settlements can also be used in conjunction with a trust. Consider the advantages of a Special Needs Trust, or spendthrift trust, especially in cases where the plaintiff is severely impaired. A structured settlement can be set up to make an annual payment to the trust, instead of a monthly payment installment, which can also increase the value of the settlement. This is another way to offset any taxes.
IRS code is very complicated and is always changing through either internal rulemaking or acts of Congress. One about to receive a jury award or settlement needs to meet with a tax adviser to determine the best way to protect themselves from unnecessary tax consequences.