Legal issues for businesses can often end in either a settlement or money awarded to a company or the person filing the lawsuit. You can also get money awarded to an individual in connection with a personal injury lawsuit. For tax purposes, there are specific rules when it comes to the treatment of that income (when is it taxable and when is it tax-free) and expenses (when are they deductible or not) that go along with the lawsuit.
In the case of personal injury lawsuits, some of the money could be considered as taxable income. Proceeds received related to physical injury or physical sickness are not considered taxable income. Any compensation related to emotional distress or punitive damages needs to be included in Income. Exception: when you receive medical care for emotional distress, only the settlement proceeds above and beyond those medical expenses is considered income to the individual.
The associated attorney’s fees are generally not deductible as an expense when you get a tax-free income from a settlement. However, if the lawsuit pertains to age discrimination such that the proceeds are taxable income, you can deduct those fees from gross income to determine adjusted gross income. Specifically, the amount of this “above-the-line deduction” is limited to the lawsuit settlement amount included in your gross income.
If you are involved in a lawsuit where you may be entitled to settlement proceeds, the overall tax treatment to the payee should be considered by you and your legal team as this may impact the negotiation of the settlement terms and ultimate payout. Please contact your Wegner professional for more information to help minimize the tax cost.