The Internal Revenue Service expects you to pay taxes on almost all the money you make, including gains from lawsuits. The exception is compensation for damages for a physical injury or sickness. If your lawsuit is performed on a contingency basis -- meaning you pay your attorney when and if your receive a settlement -- you'll pay taxes on the entire settlement.
Sickness and Injury
A civil settlement that compensates you for a physical injury or sickness will not be taxed. However, you will pay taxes on punitive damages awarded on top of the injury and sickness compensation. Punitive damages punish the parties being sued for their role in creating the situation that caused you harm. If you received $100,000 for your sickness or injury and another $50,000 in punitive damages you can enjoy the $100,000 tax-free but must pay ordinary income tax on the $50,000.
You'll also pay taxes on lawsuits stemming from an employment situation that results in a settlement for back pay or emotional distress. Emotional pain and suffering is not the same as physical sickness or disease in the eyes of the tax code. The IRS and state tax authorities consider these awards to be ordinary income and tax you accordingly.
Many attorneys litigate civil lawsuits on a contingency basis, so they get paid when you get paid. Personal injury attorneys can earn one-third of the total settlement or more. They may also charge administrative or paper work fees. If you receive a $1 million taxable settlement, you're on the hook for the taxes for the whole amount, not the amount left after the lawyer gets his check.
Lump-sum settlements can bump you into a much higher tax bracket and increase the amount you owe in taxes. That's why some settlements are structured to pay out over many years. The lower periodic payments can keep you in a lower income tax bracket and paying less in taxes over time. Instead of taking a $1 million settlement as a lump sum, you may decide to receive it as $100,000 a year paid out over 10 years or $50,000 over 20 years to keep the tax man from getting a bigger chunk.
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