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  1. #1
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    Default What Taxes Do You Pay on a Personal Injury Award or Settlement

    Are actual damages from a malpractice case taxable? How about punitive damages? Wouldn't loss of income reimbursement/award be taxable too? As well as future loss of income reimbursement?

  2. #2
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    Default Re: Is 40% Too Much for a Law Firm to Charge

    The lost past and future wages/income are not taxable when they are damages that are due directly to the physical injury caused by the malpractice. So if you lost wages because the injury made you unable to work for 6 months, the award for those lost wages are attributable to the physical injury and thus not taxed. The IRS and courts have made that clear. In IRS Revenue Ruling 85-87 the rule is stated quite clearly: "The entire amount received by an individual in settlement of a suit for personal injuries sustained in an accident, including the portion of the amount allocable to the claim for lost wages, is excludable from the individual's gross income."

    The client receives the settlement money and then turns around and pays the attorney his/her fee for the work the attorney did. If the attorney had been paid by the hour by the client from wages he earned, for example, it would be clear that both the client and the attorney are paying tax on those same dollars — the client had that income as wages which is taxable to him, and the attorney is getting paid $X for the hours he spent on the case, which is taxable to him. A contingent fee agreement is economically no different. Sure, the way the fee is calculated is different, but that's the only difference. The award is payable to the client — he's the one with the injury and the one to whom the defendant is liable. The defendant has no liability to the plaintiff's lawyer. So the award (if it is a taxable one, i.e. not a physical injury tort claim) is in its entirety income to the plaintiff. Then the plaintiff pays his/her attorney the cut the attorney is entitled to under the contract they have for the contingent fee. It works out the same economically whether the fee agreement is hourly, contingent fee, or whatever. And the point in the contingent fee case is very clear in the law, as a unanimous Supreme Court held in favor of the IRS on that very point. "We hold that, as a general rule, when a litigant's recovery constitutes income, the litigant's income includes the portion of the recovery paid to the attorney as a contingent fee." Commissioner v. Banks, 543 U.S. 426, 430, 125 S. Ct. 826, 829, 160 L. Ed. 2d 859 (2005).

  3. #3
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    Default Re: Is 40% Too Much for a Law Firm to Charge

    Quote Quoting Taxing Matters
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    The defendant has no liability to the plaintiff's lawyer. So the award (if it is a taxable one, i.e. not a physical injury tort claim) is in its entirety income to the plaintiff. Then the plaintiff pays his/her attorney the cut the attorney is entitled to under the contract they have for the contingent fee. It works out the same economically whether the fee agreement is hourly, contingent fee, or whatever. And the point in the contingent fee case is very clear in the law, as a unanimous Supreme Court held in favor of the IRS on that very point. "We hold that, as a general rule, when a litigant's recovery constitutes income, the litigant's income includes the portion of the recovery paid to the attorney as a contingent fee." Commissioner v. Banks, 543 U.S. 426, 430, 125 S. Ct. 826, 829, 160 L. Ed. 2d 859 (2005).
    I am confused. If an award is not broken down into the many categories that make it up, how can it be broken down into the category of 'income?' You said nearly none of an award is taxable.

    Typical example: If a plaintiff is awarded $500K for physical injuries and it is settled outside of court, the lawyer's fee would be about $165K. If the claim is not broken down into different categories then nearly none of the $500K would be taxable. The plaintiff would simply pay his attorney out of his non-taxed $500K, making the money he paid his attorney non-taxed. Whereas, if you hired a lawyer and paid out of pocket, those funds would be from taxed money and not be a deduction on that year's taxes. Right? So, it seems it is very different if a lawyer is paid from accident/contingent settlement money or paid from out of pocket money.

    If a person is paid $500K for an accident settlement, the IRS does not care what you spend that money on...an attorney, a boat, etc. It is not taxable! And what you paid your attorney would also be from non-taxed money.

    Am I missing something?

    So as said before, generally speaking, only punitive awards are taxable money. And those attorney fees would have taxes paid by the plaintiff and the attorney.

    Quote Quoting Taxing Matters
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    It's not a matter of categories or labels that the parties may put on it in the agreement.
    But it is, isn't it? Physical injury money as opposed to punitive money.

  4. #4
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    Default Re: Is 40% Too Much for a Law Firm to Charge

    Quote Quoting Chuck77
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    I am confused. If an award is not broken down into the many categories that make it up, how can it be broken down into the category of 'income?' You said nearly none of an award is taxable.
    The basic rule for the federal income taxation of an award is not that confusing. You seem to want to make it more complex than it is. The compensatory damages are not taxable if they come directly from a physical injury claim. Punitive damages, however, are not compensatory damages and moreover are specifically stated in the tax law to be taxable.


    Quote Quoting Chuck77
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    Typical example: If a plaintiff is awarded $500K for physical injuries and it is settled outside of court, the lawyer's fee would be about $165K. If the claim is not broken down into different categories then nearly none of the $500K would be taxable. The plaintiff would simply pay his attorney out of his non-taxed $500K, making the money he paid his attorney non-taxed. Whereas, if you hired a lawyer and paid out of pocket, those funds would be from taxed money and not be a deduction on that year's taxes. Right? So, it seems it is very different if a lawyer is paid from accident/contingent settlement money or paid from out of pocket money.
    From the plaintiff's perspective it doesn't make any difference in the tax treatment of the attorney's fees whether he pays the attorney with a contingent fee or by the hour. Either way, in most cases the attorney's fees paid are not excluded from the award nor allowed as a deduction on the return. What matters to the plaintiff then is whether any part of the award is included in income. And whether that is included in income is covered for the most part under the rule discussed above.

  5. #5
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    Default Re: Is 40% Too Much for a Law Firm to Charge

    So to put simply, if there are no punitive damages, attorney fees are not taxable?

  6. #6
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    Default Re: Is 40% Too Much for a Law Firm to Charge

    Quote Quoting Chuck77
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    So to put simply, if there are no punitive damages, attorney fees are not taxable?
    You seem to be conflating the issues of what awards are taxable with the issue of how the attorney's fees are treated, and they are two separate issues. The tax law says that that the entire award/settlement in a lawsuit is attributed to the plaintiff whether the fee arrangement is contingent fee or something does not change what the plaintiff receives in the lawsuit for federal income tax purposes.

    For the plaintiff the question then is: is that award/settlement received from the lawsuit included in income and thus subject to tax? For a physical injury tort claim, the answer is that compensatory damages directly attributable to the injury are not included in income. Punitive damages, however, are included in income.

  7. #7
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    Default Re: Is 40% Too Much for a Law Firm to Charge

    Is an award broken down by the court into the 10 or so categories that make it up? If not, just call the whole thing pain and suffering which would make it all non-taxable.

  8. #8
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    Default Re: Is 40% Too Much for a Law Firm to Charge

    Quote Quoting Chuck77
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    Is an award broken down by the court into the 10 or so categories that make it up? If not, just call the whole thing pain and suffering which would make it all non-taxable.
    It's not a matter of categories or labels that the parties may put on it in the agreement. Instead, the tax law focuses on what the nature of the injury was and what damages are directly the result of that injury. The injury must be a physical injury, i.e. an injury to the body. In most cases, the nature of the injury is pretty clear; it either is a physical injury or it isn't. If it is a physical injury, then all the actual damages directly resulting from it — medical bills, lost past and future income, pain & suffering, or whatever else — are not taxable. So there is no need to try calling the entire settlement pain & suffering or whatever label you have in mind. The category isn't important. Rather, it's whether you can connect it to that physical injury.

  9. #9
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    Default Re: Is 40% Too Much for a Law Firm to Charge

    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.

  10. #10
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    Default Re: Is 40% Too Much for a Law Firm to Charge

    Quote Quoting Chuck77
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    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.

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