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If you’ve got a settlement coming in a civil lawsuit, it’s likely that paying taxes next year is of concern to you. And rightfully so; you’ll be taxed on your total recovery if your settlement isn’t related to bodily injuries or if you’ve been awarded punitive damages. However, the IRS has made a change this year that may help ease the burden for some. In 2021, the IRS amended Form 1040 to include two line-items for adjustments to income that take into account attorney fees and court costs for certain cases.

What this change to Form 1040 means for plaintiffs

Deducting legal fees on your taxes is complicated in most cases, but for some taxpayers with settlements, the amended IRS 1040 form has improved on this issue slightly.

Under a contingency agreement, a plaintiff pays their attorney’s fee from a portion of the settlement they obtain. The net recovery is the amount the plaintiff keeps after paying the attorney fee. It makes sense to be taxed on the net recovery. However, plaintiffs must generally recognize 100 percent of their recoveries as gross income – meaning they have to pay taxes on the amount BEFORE they paid their attorney’s fee.

In 2004, Congress did enact an above-the-line deduction for employment claims, civil rights claims, and some whistleblower claims. However, it did not include a specific line item, so the deduction would go under a write-in portion – making for a confusing system and income tax investigations by the IRS. The edit to Form 1040 in 2021 makes what was previously a difficult deduction to claim a bit easier, which Wood calls a huge win in a new issue of Tax Alert.

Only certain types of cases qualify for attorney fee deductions:

  • Unlawful discrimination claims
  • Catchall employment claims
  • Whistleblower claims

Wood details the nuances of each of these types of claims. Check out his Tax Alert (linked above) for more information.

Concern over taxes is one of the biggest reasons why a non-qualified assignment is appealing to many plaintiffs who are receiving a taxable settlement. By breaking a large settlement into payments over time, a plaintiff is only required to pay taxes on the payments they receive in one year – making the tax burden way less than if they had received their settlement in one lump sum.

The Takeaway

The new Form 1040 may make a difference to your income tax if you’re receiving a non-injury settlement. If you’re about to receive a settlement and are concerned about the next tax season, consult with your tax-preparer in advance to understand how to properly report your funds. We also welcome you to contact Milestone to discuss how settlement planning with one of our experts could help with your financial and tax planning.

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