The taxation of legal settlements and fees is a complex topic. While the mechanics to make a proper claim are now easier, the rules are still complex. Below we look at six rules to consider when it comes to the taxation of legal settlements and the deduction of legal fees on your taxes.
The big difference in the above examples is that in the first two cases the settlements are taxable; in the third, they are not. As with many things in tax law, be aware that the rules are full of nuance and exceptions.
The important distinction here is the physical requirement. The IRS is unclear exactly what constitutes physical harm, but generally requires that you can physically see the injury.
To understand this a little better, take an example suit for emotional distress where you recover $200,000 in damages, with a 40 percent contingency fee arrangement with your attorney. Here, the plaintiff is going to have $200,000 in taxable income even though they only received $120,000 (with $80,000 going to the attorney). Not all lawyers’ fees face this draconian tax treatment, but this is the general rule in contingency fee cases.
These are some of the basic rules surrounding the taxation of legal fees and settlements. There are many nuances and subtleties, but what you should take away from this article is that, in many cases, there are ways to structure both any settlement received and how you pay your attorney to minimize your tax burden.