The Basics of Tax Reporting in Legal Settlements
When you collect a settlement for a lawsuit, you’ll likely also receive a Form 1099 from the IRS. This form serves as a reminder to pay taxes on your settlement; copies are sent to both you and the IRS. These forms match reported income for income tax purposes, making them critical for accurate tax filing.
In lawsuit contexts, two common forms 1099 are issued:
- Form 1099-MISC: This version can include various types of settlement payments, often termed other income
- Form 1099-NEC: Used specifically for non-employee compensation
Understanding the Difference Between Forms
The distinction between these forms is significant. A Form 1099-NEC informs the IRS that taxes for self-employment should be collected in addition to income taxes. This form is appropriate if you were a non-employee contractor suing for unpaid compensation.
However, in cases like wrongful termination or emotional distress claims, you’ll want the non-wage portion reported on Form 1099-MISC instead of Form 1099-NEC to avoid unnecessary self-employment taxes. Pay close attention because filing an incorrect form can be difficult to correct later.
Double Reporting: When 100% Becomes 200%
A surprising aspect of legal settlement tax reporting is that defendants often issue forms 1099 totaling 200% of the actual settlement amount.
- The plaintiff receives a 1099 for 100% of the settlement
- The plaintiff’s attorney receives a 1099 for 100% of the settlement
This duplicate reporting occurs because the IRS requires defendants to report the full settlement amount to both parties when payments are made jointly or through the attorney’s trust account. This is done because the defendant may not be aware of how the money is ultimately divided between client and attorney.
Legal Fees and Tax Treatment
The U.S. Supreme Court decided in the case Commissioner v. Banks that gross income for a plaintiff typically includes the part of the settlement paid to their attorney as legal fees. This means you might be taxed on money you never actually received.
To address this issue, plaintiffs should understand when they can deduct legal fees:
- Plaintiffs in employment cases, civil rights cases, and most whistleblower cases qualify for deductions
- Legal fees must typically be paid in the same year as the settlement (as in contingent fee arrangements)
- Outside these case types, deducting legal fees becomes much more difficult
- Even in personal physical injury cases, complications arise if punitive damages or interest are awarded
Tax Planning Before Settlement
It’s best to deal with tax reporting before finalizing your settlement agreement. Consider these strategies:
- Include specific provisions about which forms 1099 are to be issued
- Specify the recipients, amounts, and even which boxes should be completed on the forms
- For physical injury cases that should be tax-free, get written commitments about tax reporting
- Consider separate checks to lawyer and client when appropriate (though this may not fully prevent attribution of legal fees to plaintiffs)
Without express provisions in your settlement agreement regarding tax forms, correcting any errors later becomes extremely difficult.
Tax-Free Settlements
Some settlements can be totally free of taxation, such as cases where compensation is granted as damages for physical injury. In typical injury cases like auto accidents, damages should be tax-free, but only if there are no punitive damages and no interest as part of the settlement.
Even when you believe your settlement qualifies as tax-free, securing written confirmation about tax reporting in your settlement agreement provides important protection.
Conclusion
Understanding the tax implications of your lawsuit settlement before signing an agreement can save significant headaches and potentially reduce your tax burden. Consulting with a tax professional who specializes in legal settlements is advisable for complex cases.
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