Legal settlements can be a complicated consideration for taxpayers. They are often reported on a 1099 tax form and are also often taxable, but not always. There are some basic things to understand about legal settlements and taxes.
Can Settlements Be Taxed?
The IRS has outlined specific rules and exceptions to judging whether a settlement is taxable. There are some basic guidelines regarding how a settlement should be treated for tax purposes. It will depend on whether the settlement is for physical or related non-physical injuries, or even whether it is for punitive damages.
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Punitive damages are usually taxable, with the exclusion of awards for wrongful death. Physical injury settlements, including lost wages due to injury, can be excluded from taxation. Non-physical injuries may be included as income that is not subject to employment tax. This is why many times settlements will arrive on different documents, such as the 1099-MISC or W-2.
Settlements that are indicated on a W-2 are subject to employment taxes such as FICA for Social Security and Medicare. If a settlement is for lost profits, it is subject to the self-employment tax rate. Property settlements are often not taxable but may be subject to capital gains.
Read More: Do I Have to Pay Taxes on an Insurance Settlement?
What Is a 1099?
1099s are a series of tax forms that are used to record various types of payments. Legal settlements over $600 are often issued on the 1099-MISC with the amount indicated in box 3. If a 1099 has been issued for a settlement, there is a solid chance it is taxable.
Settlements including wages can also be issued on a W-2 form. Often, a W-2 will indicate taxes paid to the federal government in box 2. The 1099 will more rarely include withholdings for federal taxes.
Box 3 on the 1099-MISC is for "other income," not to be confused with employee, non-employee compensation or royalties. Income reflected in box 3 of the 1099-MISC can also be from prize winnings or awards. This distinction is important because it means that income in box 3 of a 1099-MISC can go directly on Schedule 1 to be taxed at your ordinary tax rate.
The IRS no longer allows the indication of non-employee compensation in box 7 of the 1099-MISC since this now goes on 1099-NEC. The benefit here is that there is little chance of settlement awards being indicated in the wrong box. Income from box 7 of the old 1099-MISC would go on the Schedule C to be taxed at the self-employment rate.
How to Treat a Settlement
There are many nuances to navigating the tax implications of a legal settlement. In many instances, a settlement award may increase tax liability resulting in owing money at tax time. Often, taxable settlements on a 1099 will go on Schedule 1 and line 8 of the 1040 tax form.
Under some circumstances, the IRS will allow the deduction of legal fees for some types of legal cases which can help offset taxable income.
Certain discrimination lawsuits will allow for the deduction of legal fees, which is taken on line 24H of Schedule 1. The IRS also allows the deduction of certain legal fees in association with helping the IRS combat tax law violations on line 24I.
There are many misgivings and fallacies about settlement awards, according to the American Bar Association. The IRS is strict about which settlement types are tax exempt.
There is little that can be done about the tax treatment of a settlement. It is advisable to seek the guidance of a tax or legal professional before making any assumptions about whether a settlement is taxable or not.
Read More: How to Tax-Shelter a Large Settlement