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The Land Advisor
The Land Advisor, Experienced Land Investor
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Experience:  Retired successful "land baron", financier and investor.
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do I pay taxes on class action lawsuit settlement

Customer Question

I received a settlement from a class action lawsuit...then got a 1099 for that same out of pocket expense is much greater than settlement amount...this is for exterior stucco repairs...Dryvit pay taxes on the amount of the 1099 or is this amount cancelled out as long as my expenses exceed the settlement amount?
Submitted: 9 years ago.
Category: Finance
Expert:  The Land Advisor replied 9 years ago.
It seems unfair, but the gross proceeds of your settlement - the amount shown on the 1099 - is taxable income. Your out of pocket costs for the class action lawsuit are deductible BUT as a miscellaneous itemized deduction.

Your expenses that are associated with the work that was done on the structure that was repaired are added to the basis (if it is your house) or deducted as a repair cost (if it is a rental property) ... either way it is NOT deducted from the proceeds of the 1099 class action lawsuit settlement.

I know it seems that the taxpayer gets the "wrong end of the stick" with this interpretation... but see below for a more formal outline of this conclusion. If you have a professional tax preparer, that is what they are going to tell you.

I have a similar situation involving securities litigation, I don't like it either!

[here begins the formal discussion]

" If you win an award in a lawsuit, or accept a settlement, it occurs after a long and hard-fought battle. After attorney fees and case costs, the money you actually receive can sometimes be cut in half. But the attorney earned those fees after all, and their fees are usually considered when determining the size of the award or settlement. What may not be considered is that in some cases Uncle Sam wants a share of the settlement as well. When lawsuit proceeds are taxable, how they are taxed can have a serious impact on the net you get to enjoy.

Physical injury or physical sickness

In 1996, the law was changed to narrow the type of lawsuit proceeds that escape taxation. Now, only damages originating in physical injury or physical sickness claims are excludable. Awards from a slip and fall accident or a wrongful death claim are therefore not taxed. Emotional distress awards are also not taxed if they are associated with such an injury. However, punitive damages are always taxable, even when associated with a physical injury or sickness. Additionally, interest received in a settlement due to delays in payment, such as when the case is appealed, is also always includable in taxable income.

Non-physical awards

Awards for non-physical injuries and all punitive damages are taxable. This would include awards received under federal statutes, such as the Age Discrimination in Employment Act. It would also include awards for emotional distress associated with non-physical claims, such as an employment claim or a contract dispute.
Attorney fees and case costs

In many cases, the attorney works for a percentage of the award or settlement. The attorney's percentage, plus case costs are deducted from the settlement, with the net amount distributed to the plaintiff. If the settlement is taxable, these costs are deductible. If the settlement has both taxable and non-taxable portions, such as in a personal injury case in which both compensatory and punitive damages are awarded, the fees must also be allocated as deductible and non-deductible.

The deductible portion of attorney fees and case costs are generally allowed as a miscellaneous itemized deduction. The problem with this is that miscellaneous itemized deductions are not deductible for the alternative minimum tax (AMT) calculation. The AMT is required for people with large deductions in certain categories, such as miscellaneous itemized deductions. An individual pays the higher of the regular tax or the AMT, and while the AMT tax rate is generally lower than the regular tax rate, the disallowance of the attorney fees and case costs can result in a much higher AMT tax. You are in essence taxed on the gross settlement, not just on your net proceeds.

Many people are surprised to learn they must report the gross settlement proceeds as income. The case costs and legal fees are deductible, but not in a manner that actually provides tax relief. It can result, in some cases, in a flat 28 percent on the gross. While some people like the idea of a flat tax, this may not be what they have in mind.

Relief available

There are instances when the fees and case costs can be deducted directly against the gross proceeds. This was allowed in a recent Tax Court case. The case had nothing to do with personal physical injury, so there was no question the proceeds from the settlement were taxable. It did however, deal with securities trading losses, so the court allowed a portion of the award to be taxed as a capital gain. The court also allocated the attorney fees and case costs between capital gain and ordinary income. Fees allocated to the capital gain portion reduced capital gains directly, with only the portion allocated to ordinary income becoming an itemized deduction. Because the nature of the claim determines whether the proceeds are taxable, and when taxable, how the gross is reported and the fees are deducted, it is important to consider this before the suit is filed. "


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