Is That Settlement Money Taxable?
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Is That Settlement Money Taxable?

Business Entity Selection and the Tax Consequences of Converting

Is That Settlement Money Taxable?

One of the frequent questions coming across my desk … Is THAT settlement money taxable?

If you happen to be awarded a settlement you need to be careful in how the money is reported to avoid scrutiny by the taxing authorities. I just closed a file today in IRS Examination the facts of which surrounded unintentional incorrect reporting of a settlement.

If you’ve made it this far in the post – thank you!  Please consider checking out the IRS Audit Technique Guide for Lawsuits, Awards & Settlements. This is the ‘playbook’ if you will that IRS Revenue Agents are obligated to follow when bringing scrutiny and troubling us with burden of proof requests.

Otherwise, do know that while wrapping up loose ends from our battle we came up with a list of 10 facts about reporting a settlement that had our good meaning taxpayer known in advance, a LOT of (my) time and (his) money would have been saved. They are as follows:

1. Whether your settlement or award is excluded from income depends on whether the nature or source of the claim was due to physical injury or physical sickness.

2. Non-excluded income from a lawsuit must be reported on an information document like IRS Form 1099-MISC sent to the plaintiff and/or the plaintiff ’s attorney as well as to the IRS.

3. Even if a portion of the settlement is for physical injuries, and therefore excluded from income, amounts paid for medical expenses that were previously deducted would need to be included in income.

4. Attorney fees are treated separately and may be partly excluded.

5. If a portion of the settlement amount was due to injury, it is excluded under IRC Sec. 104(a)(2). This includes not only medical expense reimbursement for the injury, but also any damages for lost wages or earnings, sickness due to complications from the physical injury, or emotional distress caused by the injury.

DISCLAIMER

If prior deductions under IRC § 213 or any other applicable Code section were taken (that is, medical deductions; interest expense, attorney fees, etc.) then pursuant to the Tax Benefit Rule, amounts received for reimbursement of these expenses would be taxable to the extent included under IRC § 111.

In other words if an expenses was deducted else where on the tax filings or on a business tax filing it must be also reported as income.

6. If any portion of your settlement is taxable, the attorney fees allocated to the taxable portion of the settlement are included in income.

7. Generally, the taxable portion of the settlement is reported on IRS Form 1040 Schedule Line Line 8 – Other Income.

8. Attorney fees are no longer deductible as an itemized deduction on IRS Form 1040 Schedule A as per the Tax Cut and Jobs Act (TCJA).

9. If the accident involved an automobile used for business, any taxable settlement income and associated deductible fees should be reported on Schedule C or on a business tax return if appropriate.

10. If the taxable portion of the settlement does not match up to the net amount shown on Form 1099-MISC, it is likely that IRS’ automated under-reporter (AUR) program will pick up the discrepancy.

To avoid an IRS CP-2000 letter, it is helpful to attach a statement and appropriate portions of the settlement explaining the nature of the claim and settlement and how these items were reported.

Please contact me for additional information.



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