Legal Settlements and Judgments │Big Headaches for Taxpayers Resulting in Unexpected IRS Tax Debt

You have been through a tough legal battle and finally achieve success with a hard-earned judgment or settlement in your favor. The last thing you are thinking of is handing a good portion of this to the IRS. However, that is exactly what you should be planning. Most legal judgments and settlement are taxable as income and must be reported on your tax return. How they are treated can vary significantly depending on your case resolution, type of damage to you and issuance of checks and 1099’s.

To put it simply, if you receive a settlement or judgment to replace income, it is taxable. Thus, settlements and judgments are taxed based on the origin of your claim, however there are many exceptions and special nuances. Be aware of the following popular scenarios or you may find yourself with insurmountable IRS tax problems:

Lost Profits. If you find yourself in a lawsuit suing another competing business, you may receive an award for lost profits. These types of damages are taxable as ordinary income. If you receive a severance or discrimination settlement after your employer fires you, it is treated the same as receiving wages and is taxable. However, receiving a settlement or judgment from an employer is not always taxable if the employee suffers physical injury or sickness from job working conditions. An interesting example of this is where an employee has a heart attack produced by work-related stress. In this case, the settlement from this event will most likely be treated as tax-free.

Personal injury damage. If you receive damages for physical injury and physical sickness, the award is tax-free (IRC § 104(a)(2)). However, it is not that simple because what is defined as a physical injury or physical sickness is not always clear. The standard set by the IRS is that “observable bodily harm” must be present (i.e., bruises or broken bones).

Property damage. Harm to property is only taxable if the judgment or settlement is greater than its basis. (See Raytheon Prod. Corp. v. Commissioner). If the recovery is less than the basis and the property remains in the property owner’s possession, then the basis is reduced by the recovery amount. If the recovery is greater than the property’s basis, the property owner will incur a gain equal to the excess of income tax basis.

Emotional distress damage. Damages for emotional distress are taxed unless the emotional distress is triggered by a physical injury or sickness (IRC § 104(a)(5). In that case, it must be much more than merely emotional distress.

Other damages. Punitive damages, breach of contract and interest are generally taxed.

Whatever you do, try to get tax advice before your judgment or settlement is documented by a reputable tax lawyer and never wait until tax return time to consider these issues. Also, be sure to get some legal tax advice before you enter into a settlement agreement.

Getting the proper advice is not always followed, and unfortunately many taxpayers are surprised by a notice from the IRS stating they owe quite a sizeable tax debt due to not reporting a judgment or settlement as taxable income. In these situations, if a taxpayer cannot pay off their unpaid taxes, he or she may settle back taxes for less than they owe through an offer in compromise or be put on a payment plan or installment agreement.

A reputable San Diego tax lawyer can assist you in resolving your tax problems and will provide IRS tax help in choosing the best tax solution for you. The San Diego Tax Attorneys at Delia Law have many years of IRS tax resolution experience and will aggressively represent you before the IRS for IRS settlement.  Please call for a no-cost tax attorney consultation at (619) 639-3336. We look forward to helping you.

This blog post is not intended as legal advice and should be considered general information only.

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