A taxpayer may receive a substantial amount of money in a lawsuit. There are certain tax consequences of which you should be aware. The money you receive may be taxable and, in many cases, the attorney fees that you pay relating to the lawsuit may not be deductible against the gross proceeds. The legal fees may be nondeductible for tax years 2018 through 2025 due the temporary repeal of miscellaneous itemized deductions.

There are special rules that apply to attorney fees and court costs paid by, or on behalf of, a taxpayer in connection with any action involving a claim of unlawful discrimination, certain claims against the U.S. government, a private cause of action under the Medicare secondary payer rules, and whistleblower claims.

Such fees and court costs are deductible in computing adjusted gross income.

The above-the-line deduction, deduction without itemization, is allowed only to the extent of a taxpayer’s income from such actions and is not affected by the non-deductibility rules for tax years 2018 through 2025.

The tax treatment of awards and settlements can be divided into two distinct groups. The first group involves claims arising from a physical injury and the second involves claims arising from a non-physical injury.

The claims from each of these groups will usually fall into three categories:

  1. Actual damages resulting from the physical or non-physical injury,
  2. Emotional distress damages arising from the actual physical or non-physical injury, and
  3. punitive damages.

Generally, settlements received because of personal physical injuries or illness are excludable from income. However, settlements received on account of emotional and punitive damages are taxable. Damages received for lost wages, benefits, profits, or other forms of business receipts are also generally taxable.

In many cases, a settlement may be allocated among taxable payments and nontaxable payments. If damages are clearly allocated to an identifiable claim in an adversarial proceeding by a judge or a jury, the Internal Revenue Service will usually not challenge their character (taxable versus non-taxable) because of the impartial and objective nature of the determinations. However, in the case of lawsuits that are settled before a jury verdict, the IRS closely reviews such settlements and may challenge an allocation among the various claims where the facts and circumstances indicate that the allocation does not reflect the economic substance of the settlement.

An effective tax planning strategy can help reduce taxpayer’s potential tax burden when they are successful in a lawsuit. Taxpayers are advised to discuss their particular situation with their tax professional.

Further reading:

IRC Section 61

IRC Section 104

Reg. Section 1.104-1(c)

The Tax Cuts and Jobs Act of 2017- TCJA

CC PMTA 2009-035 – October 22, 2008

Publication 4345 

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