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.