Strategy: Craft a settlement agreement in away that minimizes taxes, and do it before the agreement is signed. You’re stuck once your name is on the dotted line.
Here’s a key point in the negotiation: 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.
Instead, follow these tactics:
Describe settlements in favorable tax terms. Court-awarded reimbursements for medical expenses and personal injuries aren’t taxable.In contrast, punitive damages are taxable as ordinary income. Also, damage awards for nonphysical injuries, such as age discrimination or injury to your reputation, are also generally taxable.
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 huge.
Split off payments to your attorney. Tax law says you can deduct attorney fees that are included in a court settlement as miscellaneous itemized deductions on Schedule A.
But miscellaneous deductions are limited to the amount that exceeds 2 percent of your adjusted gross income (AGI). Plus, these deductions are phased out for high-income taxpayers, and deductions for attorney 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 splitting the award, with one payment to you and a separate payment going to the attorney. Make sure your contingent-fee contract with your attorney reads the same way. That creates a legal right for your lawyer to receive part of the award.