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Wednesday, February 23, 2011

Taxes on lawsuit settlements

 Image license: RGBstock; woodsy

Lawsuit settlements are only taxable sometimes, therefore some of the time paying taxes on lawsuit settlements can be avoided. If one has successfully won a law suit settlement, there's still work to be done when it comes to taxes. Specifically, how to identify, minimize or even eliminate tax on the settlement funds which could be costly. For example, a settlement of over $1,000,000.00 in one lump some payment could be taxed as high as 35% which could be $350,000.00. That potential tax may be a good enough reason to consider and weigh the options on law suite settlements.

Lawsuit settlement annuities

If law suit settlement funds are taxable, one way to avoid and/or reduce taxes on settlements is to receive the lawsuit settlement in the form of monthly payments or annuity. If the type of settlement claim does not fall under common law excluding tax on the annuity settlement, then taxes might still be due under an annuity settlement, however, with an annuity total income is lower than if a lump sum has been distributed. 

Since these monthly payments will reduce annual income but still allow one to receive the sum of the settlement funds, tax can be saved. For example, suppose the $1 million dollar example above were distributed as an annuity over 10 years. That would mean $100,000 in income per year, which is taxable at a lower rate than $1 million, i.e. approximately 28% or $70,000 less than if the full amount were taxable. It is important to note that even annuity distributions may be taxable under tax code and law.

Lawsuit settlement law and tax code

Distinguishing taxable from non-taxable lawsuit settlement income is a matter of understanding what the tax authorities consider taxable per Oregon Live. Moreover, if income from a settlement is taxable, but is not reported, the tax authority may have the right to seek out taxes due with or without interest and other charges. To determine if a lawsuit settlement is taxable a recipient of said award might be well guided to identify the award as compensation for damage caused by physical injury or non-physical injury. 

If a lawsuit settlement arises from circumstances such as breach of contract or the settlement includes punitive action i.e. court awarded punishment to the prosecutor, then this income is more likely to be taxable under tax code and law. The extent of tax codes, judicial rulings and laws are significant and sometimes differ. Thus, it may be advantageous to consult tax attorneys and/or accountants in light of the potential tax savings and/or avoiding any potential tax code violations and punishment.

References and sources for tax guidance on lawsuit settlements

When seeking to determine whether or not a lawsuit settlement is taxable, independent research, due diligence, legal consultation and/or accountant assistance may be indispensable. For this reason, reviewing sources such as the Internal Revenue Service and the United States Tax Court helps with acclimating to caveats, income exclusions, income inclusions, IRS codes, court rulings etc. regarding the payment of taxes on settlements. These sources can be consulted for additional information, clarification of terms or rules, or professional consul.

Lawsuit settlements can vary in size, terms/ruling and nature. The size of the settlement can influence the percent level of tax if the settlement is taxable and the terms and ruling of the settlement can determine how the settlement funds will be received. Last, the nature of the lawsuit settlement influences how tax authorities interpret the settlement. 

For example, a smaller tax settlement, paid in terms of annuity into a tax protected trust fund in compensation for physical injury is less likely to be taxed than a large settlement, paid in lump sum to the recipient directly in settlement of loss and/or damage incurred through breach of contract.

Since the potential tax savings, interest on back taxes, and punishments or late fees on unpaid taxes can be quite high, it is a good idea to consult tax attorneys, professionals or accountants for written verification of tax filing requirements. The information in this article is not intended as legal advice but rather a source of information regarding taxes on lawsuit settlements.