The Special Needs Alliance posted a blog entry this week explaining tax considerations in personal injury settlements. The post was written by tax attorney Jeremy Babener and offered some very practical advice for certain points that are missed when drafting settlement agreements. He also explained the important tax savings associated with structured settlements.
Here is a brief summary of the post:
Considerations for the settlement agreement:
- State the intent of the payor: The IRS bases its treatment of the settlement on the intent of the payor, so the settlement agreement should state the payor’s reason for making the payment. This should be supported by recitals of the facts that substantiate the reason for payment.
- Clearly allocate the non-taxable portion of the settlement: In some cases where a settlement agreement failed to demonstrate that a piece of the settlement was intended to compensate for certain injuries, the entire payment was found to be taxable. Make sure that any portion intended to be non-taxable is clearly allocated and explained in the settlement agreement.
- Some emotional distress damages may be non-taxable: Under certain circumstances, emotional distress damages may be non-taxable. An explanation of taxable v. non-taxable emotional distress damages can be found on the IRS website.
- Be careful with the 1099: In the event that a payor reported a settlement payment on IRS Form 1099-MISC, some courts have held that the payment was taxable. Including a provision in the settlement agreement that prohibits the payor from issuing the 1099-MISC (with respect to the non-taxable damages) can prevent issues on this front.
Considerations for the determining the impact of a lump sum vs. a structured settlement*:
- Alternative Minimum Tax (“AMT”): reducing taxable income by electing to receive settlement proceeds over time via a structured settlement can help the plaintiff avoid the effect of the AMT.
- Net Investment Income Tax (“NIT”): Although damages in personal injury settlements are generally non-taxable, earnings from investing those proceeds can be taxed. Investing the settlement proceeds in a structured settlement will help the plaintiff avoid being taxed on the interest income (current a max rate of 39.6% on interest income and 20% on capital gains and dividends).
- Kiddie Tax: Under certain circumstances, a child’s taxable settlement proceeds or earnings from investing the proceeds may be subject to the parents’ top marginal tax rate (for a full description of this tax, visit www.irs.gov/taxtopics/tc553.html). Placing the proceeds in a structured settlement can help protect the family from losing out on important tax breaks, and can protect the settlement income for the child.
*I would also add that in addition to these important tax savings, the structured settlement option protects the plaintiff on a number of levels—it can provide them with a stable, regular source of income; protect their government benefits eligibility; and prevent the early dissipation of their settlement.
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A West Point graduate where he served as captain and military aviator, John Bair continues his commitment to our country through his efforts within the settlement planning industry. He has represented families of victims lost in the Flight 3407 crash, offered pro bono services to the families of 9/11 victims and drafted the first consumer protection bill for plaintiffs (H.R. 3699).