IRS: Tax Implications of Settlements and Judgments

IRS: Tax Implications of Settlements and Judgments

December 18, 2020 – Special thanks to the National Structured Settlements Trade Association (NSSTA) for calling our attention to a recent brief from the IRS which addresses important distinctions in the tax treatment of various personal injury damages.

[Click HERE] to read the brief.

Today, we share this summary with our clients who require guidance on matters involving taxation when receiving injury damages.

Despite plenty of clarity on the topic, there remains sufficient misunderstanding regarding certain recoveries. How to differentiate between a physical (tax-free) injury and a non-physical (taxable) one, for instance.

Claims involving emotion distress are especially vexing to some.

This update helps address the key question every stakeholder needs to ask prior to finalizing any personal injury settlement:

“What was the settlement (and its corresponding payments) intended to replace?” 

This four-page memo doesn’t specifically address the topic of structured settlements. We remind our clients, however, that proper income planning is crucial to maximizing indemnification.

Especially when receiving taxable damages, a structured settlement can enhance the overall value of one’s settlement significantly by increasing the after-tax recovery.

Whereas all damages (except punitive damages) paid on account of personal, physical injuries are tax-free under 26 U.S.C. § 104(a)(2) whether as a lump sum “or as periodic payments,” all other damages are considered taxable.

Taxable damages, on the other hand, are taxed as income is received. When settling for a single lump sum, all taxes will be due in the year the settlement is finalized. On larger settlements, this can have a severe negative impact on a client’s net recovery.

By structuring taxable recoveries, most people can mitigate their tax burden by spreading out their recovery over several years. The net effect of this strategy is a more tax efficient settlement.

Please don’t hesitate to contact us BEFORE your case settles to ensure you preserve all your post-settlement options. Meanwhile, I hope you find this resource helpful. Let us know if you have any questions.

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