One of the main questions lawsuit claimants ask is, “Are compensation settlements taxable?” Paying taxes on court-awarded compensation settlement funds depends on the nature of the award and how it was settled.
Some types of settlements are subject to federal and state income taxes while some types aren’t. An experienced mesothelioma attorney can explain tax implications to you before moving ahead with any legal recourse.
Determining Settlement Tax
The old saying about taxes is they’re one thing in life to be certain of. That’s not necessarily true with tax laws and regulations when it comes to lawsuit settlements. To clear up this confusion about what governments might take from a settlement payout, it’s necessary to understand the different types of awards and what they’re specifically made for.
A general rule about taxing settlement awards is that any amounts referring to punitive damage awards are taxable. All other awards paid under personal injury circumstances are not taxable. Then there’s the fuzzy, gray area regarding compensation for loss of income or expected profits with the terms “exceptions” and “limitations” thrown in.
The only thing certain about settlement taxes is this is a complex area. Every person filing a lawsuit in mesothelioma or other asbestos-related illness cases needs representation by an attorney who specializes in this field and knows the tax implications. No one should have to pay more tax than legally required, and an experienced mesothelioma lawyer knows how to negotiate settlements that favor the claimant.
Taxable Compensation Settlements
The basic premise governing American civil lawsuit settlements is that all monies are taxable unless they qualify for specific exemptions. These settlement funds are considered income sources and tax must be paid at a rate proportionate to the recipient’s income bracket. Invariably, a compensation settlement sets the recipient into a much higher bracket and tax percentage on their regular income also rises.
The only tax relief is in how the settlement is structured. Entitled exemptions must clearly identify what payments are for personal injury compensation and what monies are related to punitive damage awards.
Personal Injury vs Punitive Damages
In the most basic form, personal injury awards are tax-free where punitive payments are taxable. This follows a philosophy that personal injury monies are due for pain and suffering. This has compassionate value above earned income. On the other hand, punitive awards are punishment against the defendant and not something necessarily entitled to the plaintiff. Therefore, punitive damage money is always taxable.
A key to settlement tax law is defining what money is related to personal injury expenses and what are essentially bonus amounts gifted by the court settlement. Living adjustment costs are generally tax-exempt while anything above needing to make a victim whole are taxable.
Examples of taxable settlement funds include:
- Attorney’s Fees: All legal costs are normally deducted at source before the claimant is paid. Taxes are adjusted by the law firm or sometimes are reimbursed as an income deduction on the recipient’s personal tax return.
- Lost Wages and Lost Profits: Settlements specifying amounts compensation for lost income or lost profit opportunities are considered regular income. These funds have certain deduction entitlements just as regular income funds have.
- Interest: All interest earned while settlements are being processed are subject to tax. It’s identical to income from any investment interest.
- Pension Rights: Settlements that include pension rights are taxable at the same rate any other pension income would be taxed.
Non-Taxable Compensation Settlements
The United States Internal Revenue Service is also hazy about what constitutes taxable settlements and where funds are tax-exempt. Their official guide on Settlements-Taxability states that whether a settlement award recipient must include settlement proceeds as income depends on the case circumstances and facts. The IRS states generally they “won’t disturb allocations if they’re consistent with the substance of the settled claim.” What that means isn’t clear, but it strongly suggests a settlement recipient should retain a lawyer familiar with settlement tax law.
The dividing line between taxable and non-taxable compensation settlement falls on why the money is being paid. That involves the nature of the injury or illness in the case of mesothelioma settlements. In order to be non-taxable, funds must clearly be shown as paid for personal injury. Again, punitive awards are taxable—no matter what.
There are two requirements to support a personal injury, non-taxable compensation settlement:
- There must be a provable injury or illness being compensated for. Being placed in danger without actual harm doesn’t qualify. However, developing mesothelioma from asbestos exposure clearly meets this test.
- There must be a wrongful act on the defendant’s part. Mesothelioma settlements where an asbestos producer or supplier willfully or neglectfully allowed exposure also meets this requirement. It’s a matter of fault.
Compensation for Mental Anguish
The Internal Revenue Service addresses tax exemption for mental anguish or emotional distress compensation. The IRS considers stress-related suffering as part of a physical injury or personal illness, provided it meets the two-tiered test of eligibility. Some lawsuits settlements have compensation amounts itemized with certain funds allotted to the physical injury and other funds set out to compensate emotional turmoil.
Again, the IRS limits mental anguish deductions with a caveat. The emotional distress must be directly caused by the negligent act in order to escape the taxman. If mental anguish existed before the disablement or caused the disability, then any funds awarded as compensation are considered taxable benefits. Mesothelioma claimants don’t need to be concerned with this loophole. Clearly, the revenue department must recognize that mental anguish is suffered after a mesothelioma diagnosis.
Other Issues Surrounding Compensation Settlement Taxes
Nothing about income tax is simple. Each case has different circumstances and merits that also depend on the jurisdiction where a settlement is ordered and where the recipient resides. Federal tax laws are mostly universal and equally applied across the nation. However, state income tax laws can vary.
Another variable includes who the compensation recipient actually is. Some mesothelioma compensation settlements are paid to the living victim. Others morph into wrongful death lawsuits where the estate or surviving family members receive the compensation funds. Occasionally, plaintiffs request compensation funds be disbursed between parties or released in installments rather than lump sums. And then there’s the issue of compensation coming from trust funds, workers compensation, veterans benefits or insurance settlements.
There aren’t specific rules around compensation settlement tax implications. Just as confusing are some of the tax terms like general and special damages. As the IRS puts it, it depends on all the case facts and circumstances. This is something for an experienced lawyer to handle.
Retaining an Experienced Mesothelioma Attorney
Experienced mesothelioma attorneys aren’t just skilled at litigating and negotiating compensation settlements. They’re also highly knowledgeable about what tax laws apply to settlement payouts. Each case revolves around its particular merits, but how it plays out in tax returns depends on how an attorney negotiates the payout structure and wording.
If you’ve been diagnosed with mesothelioma and wish to explore options for seeking legal compensation, then it’s important to work with an experienced lawyer. Asbestos litigation is a highly technical and intricate field. Victims deserve to retain representation from competent attorneys who have their best interest at heart. Contact the Mesothelioma Justice Network today to speak to one of our Justice Support Team members.