A frequent issue that crops up for anyone involved in a settlement is whether the money paid out is taxed. Most notably when large amounts are involved, the response is seldom simple. The money you get may seem like it’s all yours, but the IRS might also want a piece of the pie.
Not fully understanding various potential obligations with tax duties may result in unintended liabilities, which could be quite large and have potential legal intricacies for those who are high-net-worth.
Regarding taxes, Dominion approaches settlements with a relentless drive for protection and transparency. In protecting our clients’ wealth, we understand all aspects of settlement awards so they don’t fall into superfluous tax traps.
Dominion’s comprehensive wealth management serves those who want to understand, prepare for, and be empowered to safely manage post settlement responsibilities.
Taxation and the General Rule of Settlement
Normally, the IRS considers settlement awards to be ordinary income unless certain conditions are present. This distinction mostly relates to the kind of settlement: Physical injuries and related damages are typically exempted from the income tax; most other forms of settlement are not. Understanding this is essential, as the IRS requires transparency in reporting this revenue.
Non-physical settlements (in other words, damages for lost income or emotional suffering where there is no physical damage) are taxable; bodily injury or illness settlements are non-taxable. This is vital to know for our clients because it sets the bar for how settlements are approached and documented and how they ultimately get protected against too high of tax cost.
Settlement Proceeds Subject to Tax vs. Proceeds Not Subject to Tax
Even if you have both types of settlement proceeds, managing the IRS categorization of taxable vs. non-taxable proceeds is essential. Below, we outline key settlement categories and how each is generally treated:
Settlement Proceeds That Aren’t Taxed
- Physical Injury Settlements: Most awards pertaining to physical injuries, like medical expenses or even lost wages that are directly attributable to the injury, are tax exempt.
- Emotional Distress Related to Physical Injuries: If the emotional distress is a direct result of physical damage, the proceeds of these damages are also non-taxable.
- Physical Sickness Settlements: Claims for illnesses brought on by outside influences like hazardous substances act similarly to awards for physical injury; they are ordinarily exempt from taxation.
- Medical Expense Reimbursements: But settlement funds used for medical expenses not previously deducted on taxes remain non-taxable. Tax law prohibits double dipping tax benefits for the same expenses.
Settlement Proceeds That Are Taxable
- Non-Physical Lawsuits: Other than physical injuries, settlements related to wrongful termination, defamation, or discrimination are taxable.
- Emotional Distress (Non-Physical): Taxable awards for emotional distress without bodily injuries are provided.
- Lost Wages and Back Pay (Non-Physical): Loss of wages in settlements are also considered taxable income and are subject to Social Security and Medicare taxes.
- Punitive Damages: They are given to penalize the defendant and are always taxable regardless of how the settlement is fashioned, but are not given to directly compensate for losses.
- Pre- and Post-Judgment Interest: Gain from the settlement funds, on the other hand, is taxable.
Sometimes it’s helpful for Dominion’s clients to know these distinctions upfront. Done correctly, settlements are structured and reported so as not to allow missteps, giving you a line in the sand against any surprises in the form of surprise tax demands.
The Challenges That Come with Settlement Taxation
The IRS guidelines, while useful as a general framework, quickly become complicated when there are multiple components to the settlement with different tax treatments for each. Dominion’s wealth advisors walk through these minefields for you, making for smoother sailing and eliminating tax headaches.
Mixed Settlements
It’s pretty common for settlements to result in both taxable and non-taxable components. Accurately allocating these is key; an incorrect allocation potentially means paying tax unnecessarily or incurring penalties remitted by the IRS.
Reimbursement for Previously Deducted Medical Expenses
Any reimbursements received by clients that previously deducted medical expenses on their taxes are taxable in order to avoid “double dipping” the benefits.
Legal Fees
Any settlements that are taxable are subject to taxes not just on the net amount after legal fees but the gross amount, too. Many clients are unaware that legal fees come out of their pocket when figuring out how much tax is owed, so it can result in an unwelcome big tax bill.
Dominion guides clients through all of this, ensuring their settlement funds are secure and compliant so they can avoid tax audits or surprise penalties.
How to Report and File Settlement Income
There is no wiggle room when it comes to IRS documentation requirements for reporting settlement income. Income via settlements may be reported through different forms because of the nature of the income, and proper reporting protects from future scrutiny.
1099-MISC and W-2s
For instance, most taxable settlement proceeds are reported on Form 1099-MISC if the proceeds are for non-physical damages or on a W2 if lost wages.
Using Tax Software and the Role of a Tax Professional
A tax professional is a must have for high-net-worth individuals. Tax software has a basic structure but you need the guidance of an expert to accurately file your return whether you’re dealing with international tax laws or have more complex settlement types to tackle.
Through a network of tax professionals, Dominion provides clients with the insight and resources to ensure you file correctly. Our structured approach prevents clients from making missteps and secures settlement proceeds for safekeeping and reporting.
Dominion’s approach is simple: asset protection and security even when settling tax obligations. We remain up to the standards of our clients by knowing the law and using our evidence-based methods. This lets us keep everything safe from start to finish.
Reach out to the pros at Dominion today to make sure your settlement stays in your pocket and not in the government’s. We stay within the boundaries of the law so that you remain legally compliant while keeping more of what’s yours.
The Strategic Tax Planning for Settlements
While it’s rare to think of simple settlement proceeds as anything but, they can be very complicated from a tax perspective. Knowing how UHNWIs can strategically structure these funds can be the difference between a big tax bill or a more evenly handled outcome. When it comes to settlement tax planning, Dominion takes an approach centered on sound allocation and tax-favored structuring, which supports wealth preservation.
Tax Burden Reduction Through Allocation Strategies
An important part of settlement planning is the allocation of funds in a way that will optimize tax treatment. Parts of a settlement may be reported on your federal tax return as non-taxable; others, not so much.
It’s both advantageous and highly essential to properly distinguish these components, as it protect clients from avoidable tax burdens. Dominion rigorously allocates portions to their rightful categories, allowing clients to keep more of what is awarded and kept away from taxation wherever the law permits.
Which Is Better, Lump Sum Payments or Structured Payments?
Settlements are usually either a single payment or a structured payment over time. Of course, each approach has its own sorts of ramifications tax-wise. But a lump sum payment, for example, may make a client cross the threshold of a higher tax bracket, thereby increasing their liability.
On the other hand, structured payments allow taxes to be paid out over a period of time, with these payments being spread out over as many years as desired, which allows taxes to generate more gradually and with less of an impact on each individual tax year.
Dominion’s advisors research every option for incorporating the proceeds into their clients’ overall tax plan, minimizing tax exposure but also making the money readily available.
Tax Advantaged Settlement Structures
The need to reduce taxable income can go even further under some allocations. When possible, Dominion also provides strategies to adjust taxable portions of settlements in order to leverage tax exempt categories.
With tax efficiency as an element in the settlement plan design, Dominion helps clients to keep more of their wealth. This involves structuring deal settlements to determine where every possible deduction, exemption, and structuring opportunity exists so they can easily fit in with an overarching wealth governance strategy.
Dominion Lets You Keep More of Your Settlement
Settlement taxation is no small task, and as with all taxes, no client wants to run into unintended tax burdens. Dominion’s strategy for strategic settlement management means that high-net-worth individuals receive the greatest permissible amount of their awards.
At every step – from allocation to reporting – it is done with expertise and a clear eye toward compliance. Those looking for a sure thing when it comes to their tax strategy know the benefit of an assured and sure path ahead with Dominion to lock in peace of mind and protect their financial future.
In fact, if you are ready to protect your wealth and gain the most for your settlement, schedule a consultation with Dominion and see how our tax efficiency expertise and asset security know-how can work for you.
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