This post is the second in a series titled “Taxable Settlements 101, in which we answer common questions and use notable cases as examples.
Last week, I discussed the BP oil spill litigation and its tax implications for plaintiffs who received a settlement. If you’re a plaintiff in litigation and read my post, you may be wondering if your own settlement is taxable — and if so, what you should be doing now in order to prevent a big tax hit. Below, I answer a few key questions to get you started.
Is the settlement I am about to receive taxable?
As a taxpayer, any monetary award you receive is assumed to be gross income and is taxable. Fortunately, the Internal Revenue Code (IRC) permits a taxpayer to avoid paying taxes on any settlement money — aside from punitive damages — received due to personal physical injuries or physical sickness. Punitive damages refer to damages awarded that exceed simple compensation, which are awarded to punish the defendant.
If your settlement is due to a physical injury, sickness, or wrongful death, you will not need to pay tax on your settlement when you initially receive it.
If I invest my settlement money, will it be taxed?
If you invest your settlement money into a traditional investment vehicle or financial institution like a local bank, the proceeds received from your interest-bearing account are taxable. On the other hand, the IRC does provide plaintiffs with the option to invest in a tax-exempt holding account or a structured settlement. It explicitly states that 100 percent of every structured settlement payment you receive will be exempt from federal and state income tax.
My family member has been injured and I will be receiving a portion of the settlement. Will I have to pay taxes on the settlement award?
If you are a “derivative claimant,” meaning a spouse, parent or child of a physically injured person, you will not be required to pay taxes on the money when you initially receive it. The IRC states that if your claim originates from physical injury or physical sickness suffered by another person, then all settlement money — again, aside from punitive damages — is viewed as an award due to physical injury, whether or not the person receiving the settlement money is the injured party.
Once I receive my settlement, what are my options?
Your net settlement proceeds are available to you in the form of a lump sum, unless there are restrictions placed within your settlement agreement. This lump sum is the remainder after attorney fees, case expenses, liens, and any other deductions from your settlement. You also have the option to receive your settlement proceeds in part, or in full paid to you over time. Prior to settlement, plaintiffs can elect to receive settlement payments over time instead of accepting a lump sum of money at once. Doing so may allow them to do the following:
- Remain below the threshold of a higher tax bracket,
- Pay less in taxes, and
- Avoid losing the many deductions, credits and allowances that phase out with increased income.
This method of “spreading taxes” is also referred to as deferred compensation or income spreading, which in essence lowers the individual plaintiff’s annual taxable income. The process involves a one-time setup with a settlement planner to ensure compliance with the procedure outlined by the court involved in the litigation.
If you’re a plaintiff in litigation, Milestone Consulting can help you establish a personalized plan for your recovery.
ABOUT JOHN BAIR
John Bair has guided thousands of plaintiffs through the settlement process as co-founder of Milestone Consulting, LLC, a broad-based settlement planning and management firm. Milestone’s approach is comprehensive and future-focused. John’s team has guided thousands of clients by taking the time to understand the complexities of each case. They assess the best outcome and find the path that enables each client to manage their many needs. Read more about Milestone Consulting at http://milestoneseventh.com/.
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).