Settling a claim is often a pretty big relief. For months or years you fought hard in litigation to make sure you get what’s fair. The joy of winning a settlement, however, can quickly go sour when you begin to consider that taxes await you. And it’s true, settlement money is usually considered taxable income, so it’s entirely possible the IRS will take a large portion of your nice little settlement.
Usually, settlement winnings are pretty complex. For high-net-worth individuals (HNWIs) and ultra-high-net-worth individuals (UHNWIs) that live in complicated taxes, they need to be strategically managed. We know how important it is for our clients to preserve their assets and reduce taxes wherever possible – and at Dominion that is what we do.
Our clients find that they can strategically decrease the tax load on settlements legally via our skillful approach. This isn’t about avoiding taxes but rather using smart, sound, evidence-based financial strategies that let you hang onto what you rightfully have earned.
Our methods at Dominion are intended for those in the “have to pay taxes” situations, i.e., persons who would otherwise have to pay a lot of taxes on their settlement money. For our clients, we provide a well-structured, legally compliant administration of settlement taxes for maximum value in your hands and minimum exposure.
Let’s Talk About the IRS’s Default Position on Settlement Money
In order to take the first step toward reducing your tax burden on a settlement, you first need to understand how the IRS views settlement proceeds. In most situations, the IRS treats all of the settlement funds as taxable income unless there is some sort of an exclusion under the rule that governs the “origin of the claim.” This rule assesses the tax treatment of settlement money based on the nature of the lawsuit or claim: what kind of compensation is involved and why the claim was filed.
For instance, let’s say you got a settlement for lost wages. The IRS will consider your settlement payments as ordinary income, as the lost wages would have been treated as taxable if you earned them normally. Consequently, just the same, money which is received as a settlement in respect of lost profits arising out of a business dispute is also considered as business income and hence taxed as such. This means that by default most settlements are taxable.
And yet, there is a notable exception: Personal injury or personal illness settlements were tax-free. The Internal Revenue Code (Code), in Section 104(a)(2) omits you’re your gross income “the payment for any damages (except punitive damages) received (whether by suit or agreement) on account of personal physical injuries or physical sickness.” Therefore, if you have won a settlement because of a personal injury, chances are the IRS will not touch your money. Bear in mind that this is very important.
At Dominion, we have the expertise to assist clients in sorting through the specifics of their settlement to determine which pieces qualify for tax exclusion. With our guidance, we’ll help you understand your tax obligations. That is great in itself, but even better is knowing where exemptions can boost your net recovery. With our approach, the IRS’s position on tax settlements becomes less scary and easier to manage. And ultimately, you’ll ideally get to keep more of what’s yours.
Should You Use Structured Settlement Annuities?
A structured settlement annuity is one of the best ways of getting the tax burden off your settlement money. Why? Because a structured settlement annuity essentially pays the settlement in installments over years or even decades as opposed to giving it to you as a lump sum. Spreading out payments can usually lower the plaintiff’s tax bracket, which, by doing so creates lower annual tax liabilities. So, as you can see, this strategy can, on its own, deliver quite substantial tax benefits.
Here’s How a Structured Settlement Annuity Works
Rather than giving the plaintiff a one-time payout, the settlement is with an annuity provider (this’ll usually be a respectable life insurance company), which will pay off the funds to the plaintiff on a pre-determined schedule. The payment schedule can be modified to fit the plaintiff’s financial goals, and it can last years or even an entire lifetime.
A structured settlement annuity is great for its tax benefits, but it also offers some much-needed stability. A big reason why annuities are so attractive is that they give you a fixed income stream without the volatility of other investments. How can they do this? Because annuity payments aren’t dependent on the whims of the market.
Structured settlement annuities provide a chance for UHNWIs or HNWIs to combine a settlement with long-term financial planning goals, as they can be backed by predictable returns with security.
The Plaintiff Recovery Trust Must Be Leveraged
It might sound like an easy solution to settle, but you never know what’s coming when you go that route because settlements can have unexpected tax traps. Case in point, the Plaintiff Double Tax Trap. This kicks in when plaintiffs are taxed on more than just the settlement they get to keep – they’re also taxed on the legal fees paid to their attorneys. The latter can sometimes be hundreds of thousands of dollars, especially in high-stakes cases. And if things are not planned well, plaintiffs can wind up getting taxed twice on money they never actually saw.
The Plaintiff Recovery Trust Provides a Way Out
Obviously, you want to avoid this double taxation. To do this, plaintiffs move the settlement funds into a Plaintiff Recovery Trust so that the amount paid to attorneys is isolated. When this happens, you’re only taxed on what you keep. Bottom line, the Plaintiffs Recovery Trust lets plaintiffs exclude from taxable income any attorney’s fees, thereby helping reduce the plaintiff’s tax burden.
We have substantial expertise in this space at Dominion and help our clients establish and manage Plaintiff Recovery Trusts. Thus, with legal fees as high as they can be, the potential tax savings make this such a smart strategy in all but a few special circumstances. With the help of Dominion in your back pocket you don’t pay the tax twice, so you keep more of your net recovery squared away. Using our approach you get sound legal strategies that protect your wealth.
The Plaintiff Recovery Trust protects a client from unnecessary tax exposure, and that’s great in its own right. But more than that, it’s also completely legal and a legitimate means of reducing taxes without the fear of litigation. Our clients can look forward to maximizing tax efficiency with a clear conscience, all the while knowing that Dominion is staying within the bounds of compliance.
Put the Annuity and Plaintiff Recovery Trust Together
Like with almost every other case, our experts at Dominion generally mix and match structured settlement annuities with the Plaintiffs Recovery Trust for clients with large settlement proceeds. We do this to help our clients earn compounded tax savings. When these two methods are combined, the payout and attorney’s fees are taxed as little as possible for clients.
Here’s How This Combination Works
Clients are insulated from the double tax effect to attorney fees when there are tax exempted judgment funds subject to whichever causes the disadvantage double tax effect. In a structured settlement annuity, the remaining part of the settlement is paid out in periodical payments at a lower tax rate than these same payments would receive if rolled into one large lump sum payment. The powerful layering of tax advantages within this dual approach substantially increases the net recovery.
Example Scenario
Let’s say you’re the plaintiff, and you receive $1 million in a settlement. Attorney fees are $400,000. As the plaintiff, you might get socked for paying taxes on the full $1 million without strategic planning. But if you put the funds into the Plaintiff Recovery Trust, the attorney fees are not taxed, and taxes are only paid on your net recovery of $600,000. When this net amount is extracted in a structured annuity over a ten-year distribution period, the effective tax rate drops more. The result? Thousands of dollars saved annually.
Get the Most Out of Medical Expense Exclusion
Another way to keep settlement taxes as low as possible is the medical expense exclusion. Here, a part of the settlement can be used to pay for medical bills – under certain conditions – and that portion is not taxed. This exception applies to mental stress settlement funds which are linked to physical symptoms or which are caused by accidents requiring medical care.
Let’s say you’re the plaintiff, and you won a discrimination case, but you’re also diagnosed with severe anxiety or depression. By working with lawyers, you can be sure to cover those costs with part of the payment. If the medical bills are properly recorded, you can take them from the taxable income, which means it lowers the total tax load.
Let’s Reduce Your Tax Load
Contact the experts at Dominion today to ensure that you’re not paying more than you should and that you’re holding onto as much as possible.
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