Generally speaking, a dollar is a dollar is a dollar. Sure, you may have one dollar bill in your wallet that is perfect, smooth and new while a second bill in that same wallet is old, worn and dirty. But when you really get down to it, those two dollar bills are the same to you, based on the fact that they’re both in your wallet and each could buy you approximately a 1/4 of a cup of coffee at Starbucks. So, when are two dollars not equal? Easy, when one dollar is subject to tax and the other is not. That is what you need to keep in mind when entering into an agreement to settle litigation.
What many people do not realize is that proceeds from a lawsuit, or the settlement of a lawsuit, have different tax consequences depending upon the nature of the damages. For example, if you are physically injured and settle a lawsuit against the responsible party, any portion of the settlement which is compensation for the physical injury is tax free. Similarly, any portion of the settlement which compensates you for out of pocket medical expenses or pain and suffering is tax free. However, if any portion of the settlement is designed to replace lost wages during your recovery, that portion of the settlement is taxable income to you (it replaces what would have been taxable wages).
It is easy to have your litigation attorney come to you and tell you the other side has offered to settle for $1 million and just say “yes”. But there should be a little more thought into the settlement, as pertains to taxes. That $1 million could be reduced by as much as 30%-35% by taxes; so did you really settle for $1 million or $650,000? I think I’d like to know the answer to that question before I signed on the bottom line. That is why you should consult a tax expert about the tax consequences of how your settlement is structured before you blindly accept an offer.
It should be noted that the IRS is not absolutely bound to respect the allocation of damages in an agreement to settle a lawsuit. That being said, it carries a lot a weight with an IRS auditor if you can show that reasonable thought and analysis went into the allocation of your settlement between the loss of your hand (not taxable) and the potential future loss of income from your job as a hand model (taxable).
There was a good article in Forbes earlier this week on this topic.