Whenever a relatively large financial transaction occurs, it is very likely that the Internal Revenue Service (IRS) will be involved. Getting divorced? The IRS will look over the property division determination and check for errors. If so, the agency may apply applicable taxes. Win the lottery? The IRS will expect a share of the winnings? Going through a lawsuit? Yes, even during your legal woes the IRS may determine that you owe a tax bill.
How can taxpayers reduce the headache that comes with tax obligations owed after winning a lawsuit?
The most important thing to do: plan. It is important to know the impact of tax obligations before settling the lawsuit.
How does the IRS determine tax obligations on lawsuit awards?
The IRS looks at the type of lawsuit, referred to as the "origin of the claim," to determine whether or not there is a tax obligation. This determination is very complicated, particularly after recent tax reform with the passage of the Tax Cuts and Jobs Act.
For example, the IRS likely taxes lawsuit winnings for lost wages as income. However, the agency may apply a different tax rate to a pain and suffering award. It is also important to note the IRS almost always taxes punitive damages, or those awarded solely to punish the other party and deter future wrongdoing. This can be tricky, as punitive damages are often tied to personal injury cases. Why is this tricky? Because the IRS does not tax awards for physical injuries. This makes figuring out what is and is not taxed particularly difficult.
This combination is just one example of the issues that can arise and make determining the tax impact of a lawsuit very difficult to navigate. A failure to follow the rules can result in a federal tax audit. Those who are the subject of an audit by the IRS are wise to take the matter seriously. An attorney experienced in IRS audits can review your situation and discuss your options.