Why You Should Consult Your CPA when Considering a Legal Settlement

Judge gavel on pile of cashWhen you’re in the middle of negotiations for a legal settlement, you’re probably focused on consulting with your attorney. But have you taken the time to consult with a CPA about it yet? Many people are unaware that they should speak with an accountant before reaching a final agreement on their legal case, but doing so can drastically change your perception of what a fair settlement amount would be. At the very least, it will help you to get a better picture of how much you’ll actually receive in your account when all is said and done. Keep reading to learn why you need to speak to your CPA regarding your legal settlement.

Planning for Taxes

Many people are surprised to learn that their settlement amount is probably going to be considered taxable income. If you’re receiving compensation for physical harm or property damage, that portion will not be taxed. However, if you’re receiving compensation for emotional pain and suffering or punitive damages, that portion of your settlement will be taxed. This can significantly reduce your final settlement amount, so it’s important to keep those taxes in mind when negotiating a settlement amount.

If you sit down and discuss your case with your accountant before reaching an agreement with the defense, he or she can provide an estimate of how much of your settlement will be taxed. This can help you to figure out if the final amount you’ll receive still seems fair to you. If not, you can work with your attorney to negotiate for a higher amount, so that the amount you receive after taxes properly compensates you for your losses.

Considering Attorney Fees

Another surprise to many people is that you’re taxed on the full amount of your settlement—not just the portion you receive after your attorney fees. Even if you’re working on a contingency-fee basis and the defense pays your attorney their portion directly, you’ll still have to pay taxes on the full settlement amount.

But what about deducting those legal expenses when you file your tax return, you ask? Unfortunately, that’s not an option for most cases. The large tax bill passed in 2017 barred deductions for legal fees on litigation settlements. The one exception to this is an above-the-line deduction in certain employment cases and whistleblower claims. But if your case falls outside of this area, your attorney’s fees won’t be deductible on your tax return.

Understanding How It’s Taxed

In addition to understanding what kinds of settlements are and are not taxable, it’s also important to understand how your settlement income will be taxed, since different types of income can be taxed at different rates. The way your settlement will be taxed is dependent upon the origin of your legal claim—or, in other words, what exactly you’re being compensated for.

If you’re suing for lost wages due to an injury, that portion of your settlement would be taxed just as your regular wages would have been. If you’re being compensated for damage to your property, it could be treated as a reduction in your property’s purchase price and not taxed at all. Compensation for emotional distress would likely be handled on a 1099 form. A CPA can help you to understand not only what will be taxed, but how it will be taxed when you file your return so that there are hopefully no surprises down the road.

Dealing with Interest

Interest is another part of a legal settlement that will always be taxed. Even if the settlement you receive falls into a category making it entirely tax free, pre-judgment or post-judgment interest will always be taxable. Many plaintiffs who realize this find it more beneficial to settle the case rather than having it go to judgment, so that taxes on the interest are not an issue.

If you don’t take the taxes on your settlement into consideration, the amount you receive can quickly be whittled away until there’s actually very little left for you. Consulting with an attorney experienced in these matters is absolutely essential. Contact one of our expert CPAs early on in your case so that you can negotiate a settlement amount that will be fair and beneficial for you even after the IRS has taken their portion. And if you’re currently filing a return with a legal settlement from last year, be sure to work with one of our accountants so you can ensure that the settlement amount is properly reported on your return.