Are Legal Settlements 1099 Reportable? What You Need to Know
In 2019, the average legal settlement was $27.4 million, according to the National Law Review, with 57% of all lawsuits settling for between $5 million and $25 million. However, many plaintiffs are surprised after they win or settle a case that their proceeds may be reportable for taxes. The Internal Revenue Service (IRS) simply won't let you collect a large amount of money without sharing that information (and proceeds to a degree) with the agency.
Legal settlements are different than legal fees, and you have to address each in turn with their respective tax treatment. Where many plaintiff's 1099 attorneys now take up to 40% of the settlement in legal fees, the full amount of the settlement may need to be reported to the IRS on your income tax. And in some cases, you'll need to pay taxes on those proceeds as well.
Let's look at the reporting and taxability rules regarding legal settlements in more detail as a taxpayer.
What to Understand About Taxation of Settlements Generally
Taxation on settlements primarily depends upon the origin of the claim. The IRS states that the money received in a lawsuit should be taxed as if paid initially to you. For example, if you sue for back wages or lost profits, that money will typically be taxed as ordinary income. If you receive a settlement allocations for bodily personal physical injury, you are not typically taxed on those proceeds as those monies are deemed to make you whole after an accident.
Before 1996, all personal damages were treated as tax-free recoveries, including physical, defamation, and emotional distress injuries, for example. However, since 1996, to receive a tax-free recovery, your injury must be "physical," such as a physical injury or a physical sickness. Unfortunately, the IRS has not defined "physical" for this purpose of the tax code. The IRS, though, has shed some light on what is deemed physical by stating that you must have "visible harm" for an injury to be considered physical.
Any damages related to emotional distress and any resulting symptoms of emotional distress, such as headaches or stomachaches, are no longer tax-free recoveries; instead, these damages are taxed as they are not considered "physical."
Some lines are blurred here with the definition (or lack thereof) of "physical." For example, if your work environment caused you migraines, would your headaches be considered a physical condition, as headaches are, or would they be a result of emotional distress inflicted by your employer? Often, these blurred lines are offered up in argument by your attorney. However, if a Form 1099-MISC for legal fees is provided to you for all or some of your settlement, any attorney arguments go out the window, as legal proceeds reported on the Form 1099 are deemed taxable.
Other settlement proceeds that may not be taxable are medical expenses, even if they are related to emotional injuries. Reimbursement for medical expenses is tax-free. And if your case involves sexual harassment and abuse, then another set of tax laws applies. For example, if the sexual harassment settlement is confidential, the defendant cannot deduct attorney fees or the settlement payment.
Finally, punitive damages, wrongful death, emotional stress, or non-physical injuries and interest are always tax-deductible. For example, in a car accident case where you sustained physical injuries, you may receive a settlement for your physical injuries, often called compensatory damages, and you may receive punitive damages if the other party's behavior and actions warrant such an award. Although the compensatory damages are tax-free, the punitive damages are fully taxable as they relate to your sustained physical injuries. The same goes for interest, whether it's pre-judgment or post-judgment interest.
Because different types of settlements are taxed differently, your settlement agreement should designate how the proceeds should be taxed—whether as amounts paid as wages, other damages, or attorney fees. By specifying in the settlement agreement how each portion of the legal proceeds is taxed, it leaves less for discussion after the signatures have dried. Keep in mind, these agreements are not binding on the IRS, but the IRS also does not ignore them. On the other hand, if the settlement agreement does not specify how the proceeds are to be taxed, the IRS will look to the underlying claim to determine taxation, making the decision solely within its purview.
You'll need to report the payment on a Form W-2 and withhold applicable income taxes and Social Security taxes.
Contingent Attorney Fees Related to the Settlement
If your attorney or law firm was paid with a contingent fee in pursuing your legal settlement check or performing legal services, you will be treated as receiving the total amount of the proceeds, even if a portion of the settlement is paid to your attorney.
Let's look at an example. If your case is entirely based on physical injuries, such as bodily injuries caused in a car accident, then your legal settlement is entirely tax-free. However, if all or part of your settlement is taxable, such as from proceeds paid to you for infliction of emotional distress, then it's a different story.
In the latter example, let's say you are awarded a $100,000 legal settlement for infliction of emotional distress, and your attorney has a 40% contingency fee. As such, you'll pay your attorney $40,000, and you'll keep the balance of $60,000.
However, here's the sticking point. You must report the full settlement of $100,000 to the IRS, on which you are taxed, even if your attorney is entitled to a share. So, yes, you read that right. The settlement total amount is fully taxable even if you split it into separate checks. After you pay your attorney the $40,000 contingency fee, you must report and pay taxes on the full $100,000, even though you only keep $60,000.
Deductions for Attorney Fees Related to Legal Settlements
If your lawsuit involves your business, you may deduct any attorneys' fees paid as a business expense on your federal income tax. In other words, those attorney fees can be deducted above the line on your tax return.
If your lawsuit involved particular employment or whistleblower claims, then you also may enjoy an above-the-line deduction of attorney fees. However, there is some confusion in the tax code about some of these deductions, which Congress must clarify. When deciding how to deduct legal fees, be sure to get an accountant's professional advice or turn to an app like Keeper Tax to make sure you're staying on the straight and narrow.
What to Report on Your Form 1099-MISC
If you receive a court settlement in a lawsuit, then the IRS requires that the payor send the receiving party an IRS Form 1099-MISC for taxable legal settlements (if more than $600 is sent from the payer to a claimant in a calendar year). Box 3 of Form 1099-MISC identifies "other income," which includes taxable legal settlement proceeds. The amount of the settlement is never reduced by attorney's fees paid. Any portion of your legal settlement representing tax-free proceeds, such as physical injury, no reporting on a Form 1099-MISC is necessary, as these monies do not reflect taxable income. However, as we discussed above, if part or all of your legal settlements constitute back wages, then this amount would be reported on the Form W-2 as usual and not on a Form 1099-MISC.
Keep in mind, if your legal settlement contains various amounts attributable to, for example, lost wages, damages for emotional distress, and attorney fees, you'll have to break up those settlement amounts among different tax forms. In this example, you'll report lost wages on a Form W-2, the emotional distress damages on a Form 1099-MISC (since they are taxable), and attorney fees on a Form 1099-NEC.
As Benjamin Franklin said after the U.S. Constitution was signed, "in this world nothing can be said to be certain, except death and taxes." Legal settlements are no different. However, unlike Franklin's famous quote, recipients of legal settlements must understand which proceeds are subject to taxes and which are not. The resulting taxation will govern how you report your settlement, for example, on a Form W-2 or a Form 1099-MISC.
If you find yourself receiving a legal settlement, want to avoid tax issues, and you'd like some professional advice, be sure to hire an accountant or download an app like Keeper Tax to help you through the IRS's taxation and reporting requirements while giving you the confidence in filing accurate tax returns.
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