Under the TCJA, Plaintiffs Face a Higher Tax on Lawsuit SettlementsApril 24, 2018
A largely overlooked change in the TCJA is that legal settlements are now taxed in their entirety.
Under the recently passed Tax Cuts and Jobs Act, or TCJA, many plaintiffs will face higher taxes on lawsuit settlements. The new law, which has not received as much attention as other changes under the TCJA, will charge tax on the entire amount of a plaintiff’s settlement, including attorney’s fees that may take 40% of the recovery.
Some helpful background info
How are legal settlements typically taxed? Did you read our blog, "Are Settlement Proceeds Taxable?" ?
Let’s say you just settled a year long lawsuit and are awaiting the money you have worked hard to win. Before you get the celebration going, make sure you assess how that money will be taxed.
While it depends on the circumstances of your lawsuit, if you receive money from a lawsuit judgment or settlement, the IRS typically regards settlement money as income, and taxes it accordingly.
More about the tax
The new tax under the TCJA will yield a higher tax on lawsuit settlements than was previously assessed.
Let’s say that you win $100,000 in a divorce settlement. Your attorney charges $40,000, so you end up with $60,000…this is the amount you pay tax on, right? Well, under the new guidance, some will be taxed on the full $100,000.
Taxed at 100%
If the lawsuit is not related to the plaintiff’s trade or business, there is no write off for legal fees or costs allowed anymore. You are taxed at 100% of your recovery. Examples include:
- A website for invasion of privacy/defamation,
- A stock broker or financial advisor for investment advice, unless you can capitalize your legal fees
- Your ex-spouse for claims related to your divorce or children
- A neighbor for trespassing, encroachment, etc.
- The police for wrongful arrest or imprisonment
- Anyone for intentional infliction of emotional distress
- Your insurance company for bad faith
- Your tax advisor for bad tax advice
- Your lawyer for legal malpractice
- A truck driver who injures you if you recover punitive damages.
This is not an exhaustive list—experts say many other settlements will be affected by the new guidance.
What about the miscellaneous itemized deduction? Is that still allowed?
Under previous law, even if you did not qualify to deduct your legal fees above the line, you could still deduct as a miscellaneous itemized deduction. These deductions have been eliminated by the TCJA.
Exceptions to the rules
The changes will not impact qualified personal physical injury cases, where the entire recovery is tax free, and also on plaintiffs who bring claims against their employers. They are still allowed an above the line deduction for legal fees.
What about sexual harassment settlements?
The law states that legal fees and settlement payments in sexual harassment or abuse cases are non-deductible if there is a nondisclosure agreement, something that many settlement agreements include.
Questions on legal settlements and how they are taxed? Reach out to our Tax Services Team.