What Taxes Do You Pay on a Personal Injury Award or Settlement

[llworking]

I added a little clarification to your statement for the benefit of others. And with that clarification you are correct.The plaintiff won an award in your example of $1.5 million, $500,000 of which is compensatory damages and $1 million of which is punitive damages. I assume it was a personal injury case, so the $500,000 of compensatory damages are excluded from income. But the $1 million of punitive damages are subject to tax, which if the rate was 25% means he pays $250,000 in tax on the award. He also pays his lawyer 50% of the $1.5 million as attorney's fees, which works out to be $750,000. So, what he has left in his pocket at the end is $1.5 million - 250,000 in tax - $750,000 in attorney's fees = $500,000.

And since that example assumes that the average tax rate will be 25% when its likely going to be higher than that with that big of an award, and assumes no state tax then in reality under the new tax laws someone is likely going to end up with less than 25% of his/her original award with the new tax law changes...and maybe even less than that.

I personally thing that is seriously WRONG and there has to be a way to fix it if the tax law doesn't get fixed.

[Chuck77]

I believe the attorney has earned his fee and deserves it, since it was agreed upon before retaining him/her. Also, the money is unobtainable without him, just like an operation is undoable without a surgeon.

What I have a problem with is I assume a business CAN deduct legal fees, right? So why can't we?

Also, why can't two checks be written? One to the plaintiff and one to the attorney? I do it in my line of work all the time. Retain him as an independent contractor with you both as two separate entities.

[jk]

I believe the attorney has earned his fee and deserves it, since it was agreed upon before retaining him/her. Also, the money is unobtainable without him, just like an operation is undoable without a surgeon.

What I have a problem with is I assume a business CAN deduct legal fees, right? So why can't we?

Also, why can't two checks be written? One to the plaintiff and one to the attorney? I do it in my line of work all the time. Retain him as an independent contractor with you both as two separate entities.

To the two checks issue

the attorney is being paid by their client, not the other party so the other party writing two checks would not be proper.

the plaintiff is who is suing, not the attorney so the defendant owes the attorney nothing.

[Taxing Matters]

And since that example assumes that the average tax rate will be 25% when its likely going to be higher than that with that big of an award, and assumes no state tax then in reality under the new tax laws someone is likely going to end up with less than 25% of his/her original award with the new tax law changes...and maybe even less than that.

But note that the biggest reason why the plaintiff is ending up with that small portion in his pocket in this example is not the tax, it's the fee he paid his lawyer.

I personally [think] that is seriously WRONG and there has to be a way to fix it if the tax law doesn't get fixed.

I agree that the elimination of the deduction for attorney's fees was a mistake and is the wrong tax policy. The Republicans rushed through the bill to get it passed before the end of 2017 and some things were not well thought out as a result. This is one of them.

And there is no way to fix it but to fix the tax law.

I believe the attorney has earned his fee and deserves it, since it was agreed upon before retaining him/her. Also, the money is unobtainable without him, just like an operation is undoable without a surgeon.

I agree. My remark was not a criticism of the fee or implying it wasn't well earned, but simply pointing out that the biggest part of the reason why the plaintiff ends up with only a third of the total award in your example was because of the attorney's fee. The implication by llworking (which probably wasn't intended) was that the tax law was the sole reason for that.

What I have a problem with is I assume a business CAN deduct legal fees, right? So why can't we?

You're right, legal fees that are incurred as a business expense are of course deductible. And up through the 2017 tax year, legal fees incurred to produce nonbusiness taxable income were also deductible, too, as an itemized deduction. The reason we can't do that now is that Congress chucked out nearly all the itemized deductions in the tax bill it passed in December 2017. As I said before, I think that the elimination of the deduction for attorney's fees was probably not what Congress would have done had it really had the time to consider and debate the whole bill. But the Republicans rushed it through so that it could pass before Congress adjourned for the end of the year. That rush resulted in some bad changes. This was one of them. Hopefully, Congress will fix that before long. If nothing else, these changes sunset after 2025.

Also, why can't two checks be written? One to the plaintiff and one to the attorney? I do it in my line of work all the time. Retain him as an independent contractor with you both as two separate entities.

Because whether the defendant writes two checks or one doesn't change the tax result. The defendant did not retain the lawyer. The defendant has no obligation to the plaintiff's lawyer whatsoever. The defendant's obligation is to the plaintiff. So even if the defendant issues a separate check just payable to the defendant's lawyer at the plaintiff's direction to cover the plaintiff's legal fees, it is under the tax law treated as though paid to the plaintiff and then the plaintiff pays his lawyer. That reflects the substance of the situation — the only reason the defendant is paying the plaintiff's lawyer is to satisfy the obligation he owes the plaintiff. So it is still income to the plaintiff. The basic principle applied when analyzing these sorts of things in the tax law is that the substance prevails over the form. Taxpayers try all kinds of different forms of transactions to beat the tax man; most of them fail because of that principle.

[Chuck77]

To the two checks issue

the attorney is being paid by their client, not the other party so the other party writing two checks would not be proper.

the plaintiff is who is suing, not the attorney so the defendant owes the attorney nothing.

I'm not sure that is true. When you buy a new car the buyer owes the DMV charges, yet the dealership pays them. When selling a home, the new owner owes the property taxes, yet the escrow co pays them. When I see a doctor I owe the doctor fee, yet my insurance co pays it. When I write a construction contract the homeowner owes the material suppliers nothing, yet I often have the homeowners pay them directly. So I suspect it could be done if all parties agreed.

However, as TM says, this still may not avoid taxes due because of a specifically written law against avoiding taxes. But a defendant could pay an opposing attorney directly if they chose to.

[Taxing Matters]

I'm not sure that is true. When you buy a new car the buyer owes the DMV charges, yet the dealership pays them. When selling a home, the new owner owes the property taxes, yet the escrow co pays them. When I see a doctor I owe the doctor fee, yet my insurance co pays it. When I write a construction contract the homeowner owes the material suppliers nothing, yet I often have the homeowners pay them directly. So I suspect it could be done if all parties agreed.

Each of those situations are different, and none are analogous to the defendant in a personal injury lawsuit. For example, the reason your insurance pays your doctor is that you contracted beforehand for (and pay premiums for) the insurance company to pay those bills. The plaintiff in a personal injury suit has not contracted with the defendant to pay anything to his attorney before the accident and certainly has not paid the defendant for that.

However, as TM says, this still may not avoid taxes due because of a specifically written law against avoiding taxes. But a defendant could pay an opposing attorney directly if they chose to.

The defendant paying the plaintiff's attorney directly would not reduce the tax owed by the plaintiff.

Buy the way, the usual practice is for the defendant (or rather, his insurer in most cases) to make the check out jointly to the lawyer and the plaintiff. That way the lawyer ensures he gets his/her cut of the award. That will be part of any well written contingent fee agreement.

[jk]

I'm not sure that is true. When you buy a new car the buyer owes the DMV charges, yet the dealership pays them. When selling a home, the new owner owes the property taxes, yet the escrow co pays them. When I see a doctor I owe the doctor fee, yet my insurance co pays it. When I write a construction contract the homeowner owes the material suppliers nothing, yet I often have the homeowners pay them directly. So I suspect it could be done if all parties agreed.

However, as TM says, this still may not avoid taxes due because of a specifically written law against avoiding taxes. But a defendant could pay an opposing attorney directly if they chose to.

The dealership writes a check after you pay the dealership

the property taxes on a house is a negotiable matter but generally the seller pays for the time they owned it and the buyer pays for the time they own it.

An escrow is simply a company holding and distributing your money.

When you hire a construction company, you pay the entity you contracted with. Where the materials come from...well, they come from the contractor, typically. The homeowner paying them directly doesn’t make them the buyer unless you set it up that way, and you can.



in a law suit the paying entity doesn’t owe the lawyer anything...but guess what; the check is fine written to the attorney because an attorney is acting as your attorney, which allows them to accept payment on your behalf.

On top of everything else, the attorney often pays creditors from any awards. How would you work that in? A payor isn’t going to want to be involved with such a mess, even if the client attorney issue could be divided as you suggest.

[Taxing Matters]

On top of everything else, the attorney often pays creditors from any awards. How would you work that in? A payor isn’t going to want to be involved with such a mess, even if the client attorney issue could be divided as you suggest.

As a point of clarification the reason the attorney generally pays out the medical bills of his client from the money received in the lawsuit is that typically the lawyer has negotiated with the providers to accept less than they originally billed to ensure that the client is able to pay everything off from the settlement /judgment and perhaps have something left for future medical bills, if needed. But to make those settlements work, the lawyer needs to ensure those agreements are met and the providers paid.

[Chuck77]

Each of those situations are different, and none are analogous to the defendant in a personal injury lawsuit. For example, the reason your insurance pays your doctor is that you contracted beforehand for (and pay premiums for) the insurance company to pay those bills. The plaintiff in a personal injury suit has not contracted with the defendant to pay anything to his attorney before the accident and certainly has not paid the defendant for that.

That is because nothing is analogous to it.

The defendant paying the plaintiff's attorney directly would not reduce the tax owed by the plaintiff.

Yes. As I stated before.

Buy the way, the usual practice is for the defendant (or rather, his insurer in most cases) to make the check out jointly to the lawyer and the plaintiff. That way the lawyer ensures he gets his/her cut of the award. That will be part of any well written contingent fee agreement.

Why would a defendant pay the lawyer? As you both stated, the defendant does not have a contract with the lawyer. They should write the check directly to the plaintiff since the IRS sees it as all his money. Since when do we pay taxes on money that does not get paid to us nor we have access to? Then label it "income."

Here's another similar example (that is not analogous). An employer pays tens of thousands of dollars a year for an employee's health insurance. It is not paid to the employee, but directly to the insurance co by the employer...and it is not taxed. If that money went to the employee and is then paid to the health insurance co it would be taxed. Why, sidestep the employee and it is tax free, sidestep the defendant and it should be tax free too. Further, health insurance is a luxury, suing and using an attorney to right a wrong is more of a necessity.

As a point of clarification the reason the attorney generally pays out the medical bills of his client from the money received in the lawsuit is that typically the lawyer has negotiated with the providers to accept less than they originally billed to ensure that the client is able to pay everything off from the settlement /judgment and perhaps have something left for future medical bills, if needed. But to make those settlements work, the lawyer needs to ensure those agreements are met and the providers paid.

Are you saying that if a person had $100K in medical bills paid by his insurance co the lawyer can negotiate to pay them $50K and still bill the defendant $100K? And bag the extra $50K? Seems like the lawyer would be wheel'n and deal'n with other people's money.

[Taxing Matters]

Why would a defendant pay the lawyer?

Because the plaintiff's lawyer, as agent for the plaintiff, requests the check be made out jointly to the lawyer and the plaintiff. And the defendant does not care so long as the joint check satisfies the settlement or judgment. But the defendant has no obligation to the lawyer that it is satisfying by making the check payable jointly to the lawyer and the plaintiff.

Since when do we pay taxes on money that does not get paid to us nor we have access to? Then label it "income."

Any time that the obligation is owed to you but you direct the obligor to pay to someone else on your behalf. This happens all the time. You'd do that for your own convenience, but the fact that the check does not have your name on it does not mean it is not income to you. While you don't get the cash in hand, you are exerting control over it nevertheless by directing where the money goes.

Here's another similar example (that is not analogous). An employer pays tens of thousands of dollars a year for an employee's health insurance. It is not paid to the employee, but directly to the insurance co by the employer...and it is not taxed.

But the reason it is tax free is because there a particular code section — IRC § 106 — that exempts that from the employee's income. Without that specific exemption in the code, the same principle that I mentioned above would apply: it would be income to the employee even though the check is going the health insurance company rather than the employee directly.

Further, health insurance is a luxury, suing and using an attorney to right a wrong is more of a necessity.

I and many others would say that health insurance is a necessity, not a luxury. Indeed, Congress thought that too when it passed the Affordable Care Act (ACA) and required everyone to be covered by some form of health insurance.

Are you saying that if a person had $100K in medical bills paid by his insurance co the lawyer can negotiate to pay them $50K and still bill the defendant $100K? And bag the extra $50K? Seems like the lawyer would be wheel'n and deal'n with other people's money.

The defendant owes to the plaintiff whatever the judgment or settlement was for the damages incurred. The details of what the plaintiff actually ends up paying is immaterial. The reason that medical providers are willing to settle for less is that they know there is a limited pot from which bills can be paid, and they take what they can get while they can. The defendant does not get to escape its responsibility to pay for all the damages incurred simply because the plaintiff then settles with the medical providers later for less. In short, the defendant has no cause to complain that the medical providers in the end will take less.