Settling a lawsuit? 3 tips to reduce the IRS’ share
If you’re embroiled in a contentious legal dispute, taxes may be the last thing on your mind. But errors in the way you draft a settlement agreement could mean thousands of dollars going into Uncle Sam’s pocket—instead of yours.
Strategy: Try to minimize the income tax consequences of a settlement. And do it before you sign the agreement. Once that occurs, you’re stuck with the deal you made.
Here’s a key point in the negotiations: The award to the prevailing party should not be described as a single lump sum. If you take the award as an all-inclusive amount, you won’t be able to avoid taxes on significant portions of it.
It’s relatively easy to put yourself in a better tax position. Follow these simple tips:
1. Describe settlements in tax terms that are favorable to you. Court-awarded reimbursements for medical expenses and personal injuries aren’t taxable.
In contrast, punitive damages are taxable as ordinary income. And damage awards for nonphysical injuries, such as age discrimination or injury to your reputation, are also generally taxable.
2. If possible, have your attorney draft your settlements to describe part of a monetary award as compensation for medical expense or personal injury, so that portion can escape taxation. If the settlement is described as a lump sum, including punitive damages and interest, the entire award is likely to be taxed. The difference in taxes could be significant.
3. Split off payments to your attorney. The tax law says you can deduct attorneys’ fees that are included in a court settlement as miscellaneous itemized deductions on Schedule A.
However, miscellaneous deductions are limited to the amount that exceeds 2% of your AGI. Plus, miscellaneous deductions are scheduled to phase out for high-income taxpayers after 2010. Also, deductions for attorneys’ fees aren’t included in the alternative minimum tax (AMT) calculation.
It’s customary for a settlement to be reported to the recipient with a 1099-MISC form sent for the entire amount.
Tip: Request that the award be split with one payment going to you and a separate payment going to the attorney. Make sure your contingent fee contract with your attorney reads the same way. This creates a legal right on the part of your lawyer to receive part of the award. He or she is protected and you win tax-wise.
When can a business deduct legal fees?
Strategy: To secure the biggest write-offs, know what type of fees fall into each category. Make sure your attorney itemizes all your bills so you can identify expenses that are immediately deductible.
Here are the pertinent rules:
- Deduct legal fees in the current year if your lawyer represents you in an everyday business matter, such as collecting a bill, giving you general legal advice relating to the business or handling a contract dispute.
- If the legal work secures a benefit that extends beyond the current year, the fee is deducted gradually. For example, if the fee for negotiating and preparing a three-year lease is $900, you can write off $300 a year for three years. If legal fees are incurred for buying a piece of depreciable real estate, the fees are included in the depreciable basis and written off over the years. Generally, you can write off immediately or amortize over 180 months the fees to set up a new corporation or other legal entity.
- If the related property is not depreciable—for example, your home or raw land—the fee is included in the tax basis of the asset and reduces your gain (or increases your loss) when the property is eventually sold.
