Expecting Funds From A Personal Injury Lawsuit? What You Need To Know About Taxes

6 May 2015
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The point of most personal injury lawsuits is to eventually receive compensation for your injury, for any property damage, and possibly for your pain and suffering as well. But once you're awarded the money, you have to figure out the smartest way to manage it. That means considering the tax implications of a lawsuit judgement or settlement. Many plaintiffs don't stop to consider how their award will affect their tax status until it's too late. Check out the answers to a few vital questions about taxes and personal injury lawsuit funds.

Will You Owe Taxes on Your Lawsuit Award?

The first and biggest question that you need answered is whether or not you'll owe taxes on your judgement or settlement when your lawsuit has been decided. Unfortunately, the answer isn't as simple as "yes" or "no". A lot depends on exactly what you receive the award for.

There are tax-free lawsuit damages, but they're very limited in scope. Only awards that are meant to compensate you for physical injury or physical illness are considered to be tax-free. That means that in a lawsuit over a car accident, the money that you receive to compensate you for your medical bills due to an injury is tax-free; however, money that you receive that's meant to compensate you for damage to your car or for pain and suffering after the accident is taxable. If you're involved in a product liability suit and the jury awards you punitive damage in order to discourage the product manufacturer from repeating their mistake, those punitive damages are also taxable. What's more, a large award may bump you into a higher tax bracket, which means that you'll pay more taxes overall.

Are Attorney's Fees Tax Deductible?

You've probably heard of people writing off legal expenses, and you may be wondering if you can do the same. Some attorney's fees are tax deductible, but this usually does not apply to fees for lawyers involved in personal lawsuits. Usually, the only legal fees that are tax deductible are business-related legal fees. But that's not all. You will probably end up paying taxes on the money that you pay your personal injury attorney.

This is because the entire amount of the award you receive will be counted as income, including the portion that you owe your attorney as a contingency fee. So, if you receive a $100,000 settlement for something that's not a physical injury and therefore taxable, like slander, and if your lawyer's contingency fee is 30%, you'll only receive $70,000, but you'll be taxed on the whole $100,000. It gets even more complicated when part of the award is taxable and another part is non-taxable – you'll end up being taxed on a portion of what your attorney receives, but not all of it. Because this can get complicated, it's not a bad idea to sit down with an accountant to discuss the tax implications of your expected award.

Are There Tax Benefits to Structured Settlements or Lump Sums?

Your attorney may tell you that you'll have a choice when it comes to collecting your award. You can either take the money all at once (a lump sum) or you can choose to receive it in installments (a structured settlement). Both possibilities have their advantages. A lump sum allows you to immediately pay off medical bills and repair damages. A structured settlement prevents you from spending the money all at once and guarantees you an income for a certain amount of time.

The two options can affect you very typically at tax time. If you're receiving a very large settlement, taking structured payments is usually the smartest course. If your settlement is for $2 million, and you choose to receive the $2 million all at once, you'll also be taxed on the $2 million all at once. However, if you choose to receive it in increments of $100,000 a year, you'll only be taxed on $100,000 at a time. You'll pay less and stay in a lower tax bracket as well. On the other hand, smaller settlements are usually better paid in lump sums – structuring a small settlement can prevent you from settling debts in a timely manner, and carries little benefit at tax time.

By gathering tax information before you receive an award, you can make a better financial plan for your money. Be sure to ask your lawyer and your accountant to explain any details about your settlement or your tax obligations if you don't understand.