How is settlement income reported?

If you receive a taxable court settlement, you could receive Form 1099-MISC. Your liquidation income will be reported in Box 3, for other income. This is particularly true for federal income tax matters and the proper characterization of a settlement payment. For example, characterizing a settlement payment as a payment for damages due to defamation or a payment in lieu of loss of profits results in revenue for the payee.

In contrast, characterizing that same payment as a payment for physical injury or a return of principal does not imply any tax for the recipient. With ordinary income tax rates as high as 37 percent, the difference in characterization in these cases can result in a lot of income tax or no income tax at all. Property damage agreements for loss of value and property are not taxable and generally do not need to be reported on the tax return. Although the claimant will generally pay taxes on the entire settlement, including amounts paid directly to the lawyer, the claimant is likely to be entitled to deduct attorneys' fees.

The two main methods of reporting the settlement to the IRS are Form W-2 or Form 1099-MISC. Because the entire settlement, including attorneys' fees, will generally be income for the claimant, the full amount must be reported as paid to the claimant. Cases handled by personal injury lawyers are an exception to any revenue-sensitive settlement award. The third exception for when attorneys' fees are not included in the plaintiff's income is when the fees are the expenses of another person or entity, such as when a union files a lawsuit against a company.

Even if the defendant pays the lawyer separately, and even if the plaintiff receives only the net settlement after the legal fees, 100% of the money is considered received by the plaintiff. But if you first sign the settlement agreement and then request a delay in payment, you will have a constructive receipt. If the settlement agreement is explicit and denies a Form 1099, you can say that Form 1099 violates the settlement agreement. The first step in determining the taxation of the proceeds of the liquidation is to determine what exactly is being paid.

In reality, when settlement money goes to a lawyer's trust account, it is treated for tax purposes just as the lawyer receives it and the client receives it. The plaintiff's lawyer is often in the difficult position of trying to reach a settlement that reduces the amount of tax owed to appease his client, while the defendant's lawyer wants to ensure that the case is resolved correctly with as little ongoing risk as possible. More importantly, the IRS memorandum makes clear that the way the settlement agreement is drafted and how settlement payments are made can affect both parties' tax liabilities. As a general rule, almost all settlement payments in a labor lawsuit are included in the plaintiff's taxable income.

Since the settlement the plaintiff is about to receive is likely to be taxable, the next step is to establish how they should be paid through the settlement agreement. Even if an employee is no longer employed at the time of settlement payment, the payment is still considered salary subject to withholding tax.