How to Avoid Paying Taxes on Settlement Money

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How to Avoid Paying Taxes on Settlement Money

The first step in understanding how to avoid paying taxes on settlement money by correctly structuring your settlement agreement is understanding what kinds of settlement payments may be considered taxable income. When you finalize an agreement with the other party in a lawsuit, it can be a massive relief knowing that you will be fairly compensated for the damages you have suffered.

However, many people may not realize that they may incur an extra tax liability on that money, and some, unfortunately, find out these tax implications when it comes time to pay taxes the following year after they have spent much of the money. Because it may come as a shock that this money is included in taxable income, most people do not set aside the correct amount or set themselves up well.

This article will examine some tax implications on settlement payments and outline tips for avoiding paying taxes on settlement money. However, this article is not advice; it is the only issue to consider when considering how to receive settlement money, and you should seek professional tax advice before making any lasting decisions.

Determining Whether a Settlement Payment is Taxable

The Internal Revenue Code usually considers money you receive from a source taxable income unless it qualifies for a specific exemption. This means that the Internal Revenue Service, or IRS, will assume the money you receive is taxable unless you demonstrate that it is excluded from taxable settlements.

To determine whether there is a tax burden on settlement proceeds, the IRS will evaluate the origin of the claim or what caused you to bring your claim in the first place. If the reasoning behind the claim falls under one of the exceptions, you may avoid potential tax implications. However, this needs to be considered carefully to minimize tax liability and avoid tax implications later on.

Personal Physical Injury or Sickness

If you bring a claim because you suffered personal physical injuries or physical sickness, you will likely avoid paying taxes on the money you receive. Money required to compensate someone for a physical injury or sickness is tax-exempt. This ensures that all the money a person bringing a personal injury claim receives goes directly toward ensuring their recovery or care moving forward.

You may be able to exclude the entire settlement amount when the agreement directly relates to these damages, especially in wrongful death, workers’ compensation, and cases with observable bodily harm. This can even include lost wages and other compensation based on how the injury or sickness affected your life.

Medical Expenses

You may not need to pay tax on the money received to cover medical expenses, as these lawsuits were often connected to a physical injury or sickness. However, the Tax Code does allow for deductions based on medical expenses, so you may need to pay taxes on settlement money for medicinal expenses that would have otherwise been excluded.

This is because the tax benefit rule does not allow you to get double tax benefits by deducting the medical bills and claiming the money for them, which is exempt. So, if you previously deducted these costs, you cannot also claim they are exempt. Understanding what may give you the best outcome between the options is part of a tax strategy you can build with a professional.

Emotional Distress Damages

Another common form of damages that you may receive is emotional distress awards. These are compensatory damages that cover the emotional implications of the wrongdoing. Often, this type of damages in lawsuit settlements will be considered taxable settlement funds; however, if you can tie the emotional distress that you are feeling directly back to a physical injury or sickness, your settlement will likely qualify as tax-free. You may be able to exclude them from your tax return. Often, emotional distress cases are tied heavily to an injury case.

Punitive Damages

You may also receive punitive damages as a part of settlement negotiations. Unlike compensatory awards, which are designed to give back something you have lost, punitive damages are designed to punish the person who harmed you by making them give you more money.

These awards are typically taxed like ordinary income, so you must set aside the proper amounts to cover the tax liability on the settlement payment. If you receive punitive damages, getting professional tax advice for paying taxes on settlement money can be best.

A Note about Legal Fees

You will also need to consider what portion, if any, of the settlement money will be used to cover legal fees and the attorney fees you have incurred throughout the case. In cases with personal physical injuries, the settlement payment includes a portion that covers the legal fees. Typically, this is through a contingency scheme, where the attorney’s fees are taken from the settlement amount. In cases of physical injuries, settlement payments and even attorney fees are tax-exempt.

However, suppose the overall settlement payment has a tax liability attached. In that case, you may need to pay taxes on settlement money for the entire amount, including the attorney’s fees, even if you never see that money. This can make the tax returns filed the following year tricky, especially without that money being accessible to you.

Notably, the implications of a bill called the Tax Cuts and Jobs Act directly influence which types of cases qualify for tax-exempt status, so it may be helpful to speak with a tax professional to determine your liability.

Tips to Avoid Paying Taxes as Gross Income

Lawsuit settlements can be tax-free, but that is not always the case. It is more likely that your gross income will increase the year after a settlement payment, and you may need to pay your taxes for the year. The following tips provide options to consider when avoiding paying taxes on settlement payments while still allowing you to sign a settlement agreement and be compensated.

Structured Settlement Annuity

You may consider a structured annuity if you receive a large settlement agreement but cannot get the settlement payments excluded from your gross income. This is an agreement with a bank or insurance company for them to hold the full settlement amount and send you smaller payments over a few years. This allows you to only pay taxes on the smaller settlement payment you receive each year rather than paying it all in one go. You also earn post-judgment interest on these accounts, allowing you to receive more throughout the payment scheme.

Qualified Settlement Funds

Other accounts let you defer your tax liability, such as a plaintiff recovery trust or qualified settlement funds. With the proper reporting, these funds can help you avoid taxes on settlement money and ensure that you see the most from your funds, allowing you to earn interest and other benefits.

Seek Professional Tax Advice

Whether you are suing for a physical injury or lost profits, it is best to enter a settlement negotiation with a plan of attack to structure your settlement to take advantage of tax-free money and avoid paying taxes on as much settlement money as possible. A professional will discuss your income and how a potential settlement payment may impact your situation. They can help you develop a smart tax strategy to get the most money from your settlement agreement.

Contact ADR Times today to learn how to avoid paying taxes on settlement money, settlement agreements, negotiations, and more!

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Emily Holland
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