I am a long-time lurker, first time poster. I have searched the archive for an answer, but to no avail.
I am curious to know how lawsuit settlements are paid out, and if they are taxed at all. (And no, I don't have a lawsuit pending against anyone!)
I recently read an article in my local paper about a man who was now a parapalegic, due to injuries received from the police during a routine traffic stop gone awry. The official investigation found the police innocent of any wrongdoing, but the man did sue the city. Citing rising legal costs, the city settled out of court for about 1.4 million. I found this to be a rather smallish sum, considering the fact tat this man has lost the use of his legs.
I would appreciate any input. Thanks!
My uderstanding is that some settlements aren’t taxed. I recall a case documented in News of the Weird a few years back.
Seems this guy, the owner of a small manufacturing company, was injured by one of the plant’s machines. In his capacity as an employee of the company, he sued the company (remember, he owns it) for negligence. The suit was settled for a six-figure sum.
According to the NOTW story, the guy didn’t have to pay tax on the settlement, and the company got a deduction on the settlement. Needless to say, this got the attention of the IRS, who took the matter to tax court, where the IRS lost.
The full NOTW story can be found on the News of the Weird search page by entering “irs”, “settlement”, and “injured”.
Some damage awards or settlements are taxable and some aren’t. Generally, if the award was for lost earnings, back pay, and other taxable personal or business items. They would also be taxable if the taxpayer had previously deducted what they are reimbursing from his or her taxes (i.e. damages were for medical expenses, and the medical expenses had been previously deducted as an itemized deduction). On the other hand, awards for personal injury, pain and suffering, and the like are generally not taxable.
As to the news of the wierd story, I think that there may be something missing there, because injuries to employees are usually covered by workers compensation, and therefore employees are unable to directly sue their employers for personal injury damages. There are, however, several ways that employees can recover from their employers, through third-party suits, etc. I’d have to know more to comment on it.
Anyway, as to the taxation of damages or settlements in particular cases, you would have to consult your lawyer or tax advisor.
The case is Maxwell v. Commissioner of Internal Revenue, 95 T.C. 107 (Tax Ct. 1990) (unfortunately I do not have a link to an available site). As I suspected, it has to do with workers compensation.
The case turned on the fact that Mr. Maxwell, who was injured by a machine on the job, was improperly excluded from the worker’s compensation policy. Mr. Maxwell owned 47.5% of the stock, his wife owned another 47.5%, and two others owned 2.5% each, and each of the stockholders was a corporate officer. The company had excluded the officers from its workers compensation policy, but because one of the stockholder/officers was not a director, under California law, the officers should not have been excluded from workers compensation, and therefore the company was fully liable for Mr. Maxwell’s injuries. He got outside counsel, and the company’s directors (other than Mr. Maxwell, who was not present for the vote) agreed on the settlement amount.
The key point in court’s decision was that the amount of the settlement was fair compensation for Mr. Maxwell’s injuries. Essentially, the court looked closely at the transaction because it was between closely related parties, but it found that the settlement was was fair compensation, and therefore it would be treated for tax purposes like any other settlement of a similar claim between unrelated parties.
The section of the Internal Revenue Code that governs personal injury recoveries is, 24 U.S.C. Sec. 104, which provides:
There is a lot more in the law that I have not quoted, including an exclusion of emotional distress damages, so again you should see a tax advisor for specifics. The short answer, however, is that if the $1.4 million recovery by the man who was rendered parapelegic was for his physical injuries, it will not be taxable.
As to how they are paid out, if the defendant’s loss is covered by insurance, the insurance company cuts a cheque. If the defendant’s insurance doesn’t cover it, and the defendant doesn’t have the cash, the parties can either agree to a schedule of payments, or the plaintiff can use court processes, like writs of execution, to have the court officials (called “bailiffs” or “sheriffs” depending on the jurisdiction) seize the defendant’s property and put it up for auction.
In personal injury suits, one of the options is the “structured settlement” - the defendant pays the money into an annuity (or similar financial instrument) that will pay regularly over the lifetime of the defendant. This approach is used for cases of serious personal injury, where the defendant typically can’t earn much money because of disability, and wants some assurance that he/she won’t outlive the money awarded by the court.
One other factor is that if the defendant’s lawyers took the case on contingency (i.e. - a percentage of any proceeds), the defendant won’t get all the money the court awards - the lawyers get paid out of the judgment. Contingencies are used in cases where the defendant can’t afford to pay a lawyer upfront, and would otherwise not be able to bring the case to court.