First, the obvious. This is not to be construed as tax advice.
Now for some interesting nuggets.
When people sue one another (or even threaten litigation) and money changes hands, there are tax implications. A recent article by Robert Wood dives deeper.
(A) Settlements and judgments are taxed similarly. Whether you come to a meetings of the minds on the courtroom steps – or a jury imposes its will on you, the outcome typically receives similar tax treatment. This is so even before litigation begins, such as when someone sends you a threatening letter. That said, a plaintiff typically has more flexibility in reducing his tax burden if a case settles rather than waiting for a jury to opine.
(B) Some recoveries trigger no taxes. Zip. Nada. Tax Code Section 104 eliminates federal taxes for “physical” injuries and sickness. Prior to 1996, the broader category of “personal injury” damages were tax free. That bucket included emotional distress, defamation, loss of consortium. After 1996, there had to be an observable boo boo (or more). The IRS has stated you must have visible harm for injuries to be understood as physical. So, if a plaintiff sues for intentional infliction of emotional distress, and that alone, any recovery is taxable.
What about combinations of physical and emotional damages? If the stress of some dispute caused a physical ulcer, is any recovery taxable or not? How a plaintiff (and defendant) characterizes a settlement in a formal, written release impacts the ultimate treatment.
(C) Medical Expenses are not taxable. If a plaintiff’s damages are all emotional, but he seeks care with a psychiatrist, counselor, and a host of non-traditional providers, such medical expenses do not trigger taxes.
(D) Allocating damages can save $$$. As noted earlier, if a jury determines how damages are characterized, that’s the template. But, if you settle these matters beforehand, and if it passes the sniff test, there’s more flexibility. The IRS is not bound by such agreements, but apparently they are often respected. For example, in an employment dispute, there may be some wages (W2 taxable); some emotional distress (1099, non-wage income); some reimbursed business expenses (typically non-taxable); some pension benefits (usually non-taxable); perhaps some personal physical injuries or physical illness (potentially non-taxable). So, lots of complexity.
(E) Attorney fees. Typically if you are the plaintiff and use a contingent fee lawyer, you will be treated as having received 100% of the money recovered by you and your attorney. This is the case even if the defendant pays the attorney directly. If the damages are fully non-taxable, for example associated with recovery solely for physical damages, then this poses little problem. But, if the recovery is taxable in whole or in part, this can be an issue. Imagine a plaintiff sues for defamation, collects $100k, and assume it’s fully taxable. The plaintiff collects keeps 60k. The lawyer keeps 40k (not an unusual contingency agreement). The plaintiff is treated as having $100k of ordinary income with a $40k miscellaneous deduction. For many plaintiffs, they’ll get the full deduction. But, often there are limitations on how much of a deduction you can use. Consider, for example, alternative minimum tax. There are exceptions and nuances to these principles, so anyone on the receiving end of a settlement / judgment should check with a tax professional.
Litigation by itself is complex. Adding in the tax implications makes it more complex.