Legal settlements and awards can cause major problems for taxpayers. Why, you may get hit with an assessment for unreported income two years down the road. Since many settlements are of large dollar amounts, the penalties and interest over that two year period can break you. There is another pitfall, if you decide to sell the rights to a structured settlement, of which I will discuss later.

Your Settlement May Be Taxable

The most important thing to remember is that unless your settlement is for a physical injury, you will have to pay income tax on the entire award.

Attorney Fee Allocation In Settlement May Be Taxable To You

The second most important thing to remember, is that your settlement portion relating to attorney fees is taxable. Accordingly, money you never get, money that is siphoned off by your legal counsel, will be included in your income, and you will pay tax on it.

My accountant says "Don't worry, its not taxable." I can't believe how many times I have heard that coming from a fellow business owner. I wonder if your accountant is going to answer his phone when you learn that you owe tens or hundreds of thousands of dollars in tax, penalties and interest. That is very common, by the way.

The Law Behind The Tax

A little about the law behind the rules I just described. The code states that income is just about everything you receive in value unless it is expressly exempted from tax under the law. Title 26 of the US Code Section 104 (26 USC 104(a)(2)) creates an exclusion from taxable income, relating to legal settlements. The Supreme Court settled a dispute between the Federal District Courts of Appeal in its holding in Comm v Schleier (1995). In Schleier, the Court set out two independent requirements that a taxpayer must meet before a recovery may be excluded under 26 USC 104(a)(2). The taxpayer must demonstrate that the underlying cause of action giving rise to the recovery is predicated upon a legal tort or legal tort type rights and second, the taxpayer must show that the damages were related to personal injuries or sickness.

Tax Deduction For Attorney Fees

Do you get to deduct the attorney fees? Yes, in theory, but in practice, due to the alternative minimum tax (AMT), probably not. The reason is that the attorney fees are a miscellaneous itemized deduction subject to the 2 percent floor and that deduction is phased out for high income taxpayers, under the alternative minimum tax regime. Alternative minimum tax kicks in around 71,000 for a joint filer. What the 2 percent floor means, is that you must subtract 2 percent of your adjusted gross income from the attorney fees before you get any deduction and before the AMT kicks in.

Selling Your Structured Settlement (not Capital gain)

If you have a legal settlement that involves an annuity type cash flow or structured settlement, you can get into trouble. The reason for this is, that a person is taxed on the actual or constructive receipt of money. While you are receiving your structured payments, you will only recognize income when you receive either the payment or the rights to the payment. Think about what happens when you sell your right to receive all the future payments. You are selling an asset worth x x amount of dollars and you will have to pay income tax on that amount. But what is that asset worth? The amount realized on that transaction is the present value (PV) of all future cash flows, discounted at the appropriate interest rate.
The situation can go south fast when you sell this asset for less that the tax liability, which can happen very easily.

You will also not be allowed to convert your ordinary income to capital gain by selling your settlement proceeds to a third party. See Davis v Comm (1997). You are selling your rights to receive the income payments, not a capital asset.

There are many companies out there waiting to buy your structured settlement for pennies on the dollar. Its your cash, get it now? Caveat venditor!!

26 RIVER HILL ROAD MURPHY NORTH CAROLINA 828 494 4170  Webmaster@JCRogersCPA.Com