Understanding the Tax Implications of Lawsuit Settlements: The Importance of Using a Calculator for Precise Outcomes

The Importance of Tax on Lawsuit Settlements

The tax implications of receiving a lawsuit settlement have a significant impact on the final amount received by the plaintiff. If a person fails to properly analyze the effect of their lawsuit settlement for tax purposes, they could significantly overpay in taxes, both in the present and in the future. Additionally, the tax impact of any lawsuit settlement can significantly impact the perceived value of the case, both as a practical matter of value and as it relates to the client’s tax situation.
Without understanding the different types of damages at issue in litigation and the tax ramifications of each, a plaintiff could lose hundreds or thousands of dollars to the IRS. Similarly, a plaintiff may accept a lower value on a case out of a concern about how much they will owe the government after the settlement, when the case may actually be worth much more. Sometimes, it may make more sense from a tax perspective to have certain types of damages include in the settlement agreement, while other times the reverse is true. If a plaintiff is unable to determine the full monetary value of their lawsuit settlement, due to the effects of taxes, the proper result would be to hire and consult with a qualified professional who can help calculate the actual monetary damage.
Not all lawsuit settlements are equal and the IRS treats different types of damages awfully. Settlement of lost wages may carry a high tax obligation for the plaintiff, while settlement of other damages may be totally tax free. Confusion about how damages are classified by the IRS leads many taxpayers to overpay the government on their lawsuit settlement and this is highly unfortunate.
In a nutshell, the reason why lawsuit settlements matter for tax purposes is because the IRS distinguishes from one type of damage to another. For example, damages for lost wages that are intended as income replacement are taxable to the plaintiff, while damages for physical injury -or alternatively known as physical sickness- are tax free to the plaintiff .
There are various ways to ensure that a lawsuit settlement is taxed at the correct rate. First, it is possible to classify a lawsuit settlement payment for tax purposes, in certain cases, prior to the lawsuit being resolved. This is done by means of a "Stipulation," which is an agreement between the affected parties litigating the lawsuit and the IRS. The attorney can assist a plaintiff with preparing and filing the necessary paperwork for a Stipulation with the IRS.
Another option is to seek court approval from a court to resolve the lawsuit. Depending on the composition of the settlement agreement, it may be possible to obtain court approval and have the settlement deemed by a certified, disinterested judge (sometimes know as an Article III judge) to be properly classified by the IRS. The IRS usually will not seek to classify a lawsuit settlement unless a question arises with how the parties have classified it in the documentation. This is an important aspect of lawsuit settlement taxation as if an individual allows the IRS to classify their settlement into categories of damages, the IRS will always classify the payment as taxable wages under Section 861 of the Internal Revenue Code.
For example, if someone were to go to court to obtain judicial approval of the damages recovery in the lawsuit settlement, the IRS would respect the court’s opinion and would not seek to reclassify the award as a wage replacement. It is also worth noting that the earning potential and age of the individual may be relevant in determining what type of damage award is most appropriate.
For purposes of analyzing and calculating lawsuit settlement award, there are specific tools available that help individuals ascertain the maximum monetary recovery they could receive, while also analyzing the potential tax effects of the recovery as well. These software programs provide the individual with an accurate and informative tool that can be used to assist them with obtaining the result they desire.

What is a Lawsuit Settlement Tax Calculator?

The function of the lawsuit settlement tax calculator is to enable individuals in the settlement phase of a lawsuit to obtain a first approximation of their tax liability on a settlement of their claims. These estimations will then allow them to go and further investigate discovery documents or other information to obtain a more reliable approximation of the actual tax liability on their lawsuit settlements. After that point they can turn to a tax professional to form a final determination. The calculation is a search engine-like tool that will ask a number of questions that match up the nature of case and its relationship to the individual’s tax history to determine how much of these settlement (if anything) will be taxable. Although the laws are the same throughout the United States for the taxation of lawsuit settlements, there are some nuances in operation from locality to locality. In addition, certain aspects of the tax law are subject to interpretation. The lawsuit settlement tax calculator is one way of estimating the final tax liability on a lawsuit settlement. Due to the fact that this calculator can use assumptions as inputted by the user, it can provide specific and short-turnaround approximations if needed.

Types of Settlements and Their Appropriate Tax Treatment

Types of Lawsuit Settlements and How They Are Taxed
The most common types of lawsuit settlements are for personal physical injuries, non-physical injury and punitive damages.
Personal physical injury lawsuit settlement is exempt from federal tax. According to the Internal Revenue Code, "lump-sum amounts received as a result of a lawsuit [for physical injury or physical sickness] are excluded from an individual’s gross income under § 104(a)(2) of the Internal Revenue Code and therefore are not subject to federal income tax." The ruling goes on to specify that the tax-free recovery for sickness or physical injury also includes punitive damages. "Punitive damages are paid for personal physical injury or physical sickness under § 104(a)(2) if they stem from a physical injury."
However, the exemption from tax only applies if an award is made as a result of a physical injury. If a physical injury is not involved in the settlement, you must include the amount received in your gross income. Examples of non-physical injury are wrongful imprisonment, libel and breach of a confidentiality agreement.
Punitive damage lawsuit settlements are not usually excluded from income. A lawsuit settlement award that is not just for physical injury or sickness is generally taxable to the recipient. However, it can be difficult to determine whether the punitive damages in your lawsuit settlement are taxable. Accurately distinguishing between the different types of litigation settlements and understanding the tax treatment of each can help you figure out whether a lawsuit settlement award that is supposed to be exempt from tax can actually reduce your tax liability, or if you should use a calculator to determine if you are being taxed more than you need to be.

How to Calculate Your Tax Obligation

If you do not want to worry about Section 106 problems, you can use a lawsuit settlement tax calculator. These are online programs that calculate your tax liability based on the amount of your settlement and your tax rate. You input the amount of your settlement, your tax rate, and it automatically calculates your total tax owed for the settlement.
So let’s say you get a $200,000 settlement. Your tax rate is at 32 percent. You’ll owe $64,000 to the IRS.
Your tax liability will be significantly higher if you take payments on your settlement. But it can be difficult to calculate exactly what you’ll owe or to know if the tax rate is correct. But with a tax calculator, that’s not a problem. You input the information, and you have your answer. This is a great tool to make sure that the Internal Revenue Service is not taking more money than it should.

Factors that Could Impact the Calculation of Your Settlement Tax Obligation

Settlement tax calculations may be affected by state laws, deductions, and exemptions. One of the most common reasons for the reduction of federal taxes is because certain payments are not taxable income or may be deducted from taxable income. For example, some amounts generally included in the gross settlement amount may be non-taxable as punitive damages, interest (in certain circumstances), medical payments, or workers’ compensation payments . Taxes for interest are deferred until the funds are received by the recipient. In addition, medical payments may be excluded from gross income and are not subject to federal taxes. Although workers’ compensation payments are typically not taxable, periodic payments may be subject to indirect taxation, such as state premium taxes. Numerous small factors may also have a significant impact on settlement tax calculations. These factors can include deductions and exemptions, as well as the effect of marginal tax rates.

Common Errors in the Calculation of Your Settlement Tax Liability

Common Mistakes When Calculating the Taxes on Lawsuit Settlement Amounts
One of the most common mistakes I see is people calculating their taxes on the settlement of a lawsuit by simply adding up all the applicable taxes and then multiplying that number by whatever portion of the settlement they think is statutory damages. Some people think that because they can prove "physical injuries or physical sickness," the entire settlement amount will be excluded from income tax. First, realize there is a difference between pain and suffering damages and physical injury damages. Physical injury damages are adjustments to gross income. Pain and suffering damages are added to gross income. Usually a settlement consists of pain and suffering damages and physical injury damages. Sometimes it also includes wages or property damage, too. Let’s take a look at each of these. Any portion of the settlement that is wages or wages equivalent must be included in income. Adjustments to gross income are found on line 33 of the 1040 form (see form instructions here). For personal physical injuries, 100% of the medical expenses are deducted line 33 of the 1040 form. If there is no physical injury (like an emotional distress lawsuit), only unreimbursed medical expenses that are over 10% of your adjusted gross income are deducted on line 33 of the 1040 form. Unrealized medical expenses on lines 21 and 14 on the 1040 form are not deductible. If mental suffering or emotional distress is caused by an injury that was characterized as physical, then any damages for the emotional distress are not taxable. However, damages for emotional distress as a result of mental anguish are considered pain and suffering and must be included in gross income. Usually, personal injury cases involve both physical damages and pain and suffering damages. A lawsuit settlement may include a provision where all damages are lumped into one amount with no portion designated to each type. Where income must be determined and the settlement agreement doesn’t provide for it, the taxpayer must make a reasonable apportionment to the different types of damages that are considered for taxation purposes. If you aren’t sure how to calculate the taxes on your lawsuit settlement, then please use my lawsuit settlement calculator or hire a professional to do it for you.

Expert Assistance in the Calculation of Your Tax Liability

While we often advise clients of an estimated tax impact of a particular number, we will not calculate the exact amount of taxes on a suit settlement. Then, we will always advise to seek professional tax advice, which is how we first arrived at the above number. While certainly there is a lot of information available online about lawsuit settlement taxes -much of it freely available-working with a tax professional is the best way to determine the possible tax implications of a particular case. Tax professionals can look at the possible settlement scenario and recommend the best way for your settlement to come out to minimize taxes. In addition, as mentioned above, a final tax return is always necessary to determine the actual numbers. For this reason, a tax professional is also necessary. For those that do not have significant taxable income, and even a few other relatively common scenarios, taxes might not even be a consideration of your settlement.

Conclusion: How Settlement Tax Calculators Can Help

In sum, while these calculators are not a perfect device, it does allow the user to rapidly determine the before-tax equivalent recovery amount. Likewise, you can use the calculator to determine the various forms your settlement can be structured to maximize the tax efficiency of the settlement .
What I have found is a majority of the time, the parties will still choose a lump sum recovery despite what looks like a better deal with a structured settlement. But, you now have the information you need to critically look at the tax ramifications of your settlement and make an educated decision.