Article by: Jeff Skolnick, CPA, M.S. Taxation

You have received a legal settlement and you are now wondering whether it is considered taxable income or not. Like many things in the tax code the answer is sometimes. I will now explain when settlements are taxable and when they are not.

Settlements related to physical injury or illness

Internal Revenue Code (IRC) 104 states “the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness are not included in gross income.” More simply put settlements related to physical injury or sickness are generally not includable in taxable income. I say generally because as I stated in the legalese definition punitive damages related to settlements are still taxable as is interest income on settlements (when settlements are received over a number of years).

Physical injuries and sickness can include reimbursement of medical expenses, lost wages and pain and suffering. You must be careful. If in a prior year you deducted medical expenses due to your injury, then the reimbursement of those expenses would be taxable. For example, if you were injured in 2019 and deducted $10,000 of medical bills and received a $50,000 settlement in 2020, you could exclude $40,000 from income in 2020. You would not be able to exclude the $10,000 reimbursing medical expenses which you had previously deducted. Also keep in mind if your settlement specifies a certain dollar amount for future medical expenses than you cannot deduct medical expenses incurred in the future until they exceed the amount stated in the agreement. If future medical expense reimbursements are not specified in the settlement, the you are able to deduct future medical expenses as itemized deductions.

Nonphysical injuries

Generally, any settlement received that is not related to a physical injury would be taxable income. An example of this would be wrongful termination. Once again, I use the term generally. The reason for this is that if the award originates form a physical injury or sickness then it is excludible (except in the case of punitive damages which are always taxable). Emotional distress is not considered a physical injury or illness but if the cause of the emotional distress was a physical injury or sickness then the amount received for emotional distress is excludable. Please also keep in mind if the award is considered back wages (for example based on wrongful termination) not only will it be subject to income tax, but it will also be subject to payroll taxes (Social Security and Medicare taxes).

Punitive damages

Punitive damages are those awards aimed at punishing the guilty party. These are taxable whether related to a physical injury or sickness or not.

Settlements containing reimbursement for taxable and nontaxable items

Let’s say you receive a settlement that includes both payments to reimburse you for physical injuries as well as reimbursement for wrongful termination (a settlement that would be taxable), is it taxable? The answer is part of it would be nontaxable (the portion related to your injury or sickness) and part would be taxable (portion related to the wrongful termination).

Can I deduct legal fees?

Prior to the Tax Cuts and Jobs Act (TCJA) most of the time legal fees were deducted as part of miscellaneous itemized deductions on Schedule A of Form 1040. Under the old law you could deduct legal fees on settlements where you had to pay income tax on those settlements. In other words, if you didn’t have to include the income from your settlement (for example from a personal injury), then you were not allowed a deduction. If your settlement was includable in income (such as from a wrongful termination), you could deduct your legal fees on Schedule A.  Unfortunately, the TCJA eliminated itemized deductions and these fees are no longer deductible.

There are, however, some cases where legal fees can still be deducted on your Form 1040.

Business

If you incur legal fees related to your business (such as a Schedule C sole proprietorship or single member LLC), these expenses would be considered ordinary and necessary expenses allowed as deductions on your return. Examples of these expenses would be reviewing contracts or providing tax advice. There are certainly many other examples, I just want to give you a few examples.

Rental Property

If you incur legal expenses in your rental business they would qualify as deductible. Examples here could be drawing up leases or evicting a tenant.

Instances where legal fees can be deducted “Above the Line”

Above the line refers to deductions that occur above the Adjusted Gross Income Line on an income tax return. The reason this term is so important is that it means that taxpayers will receive the deduction (or adjustment) whether they itemize their returns or not. Some examples of above the line adjustments include IRAs and self-employed health insurance. You would receive these reductions to your income whether you itemize deductions or not. 

The law states a few specific situations where legal fees can directly offset part or all of a taxable legal settlement. These situations are as follows:

Employment discrimination Cases. In these cases you can deduct any legal fees from the gross amount of your award.

Whistleblower cases. If you receive an award for being a whistleblower you can deduct any associated legal fees.

Other

Legal costs incurred in obtaining property may be capitalized. An example of this might be attorney fees for a closing on a piece of property. In this case the legal fees are added to the purchase price and depreciated over the life of the property.

Conclusion

Legal settlements and associated legal fees have always been surrounded by confusion. As you can see some elements of a settlement are taxable and some are not. Additionally, some legal fees are deductible, and some are not. I certainly do not claim to have covered every element in this discussion, but I wanted to provide a general sense of understanding. Legal settlements are a complicated area of the law and very often involve significant dollar amounts. For these reasons I urge you, as always, to consult with a tax professional well versed in this area of the law.

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