Understanding the Tax Implications of Receiving a Medical Lawsuit Settlement

Overview of Medical Lawsuit Settlements and Their Taxation

Medical Lawsuit Settlements and Their Taxation

Medical malpractice, personal injury, and wrongful death lawsuits can result in the plaintiff receiving a settlement or verdict payout from the defendant. While these settlements provide compensation for the plaintiff’s damages, they also have tax implications.

Types of Medical Lawsuit Settlements

There are two types of medical lawsuit settlements: compensatory and punitive. Compensatory settlements compensate the plaintiff for their actual losses, such as medical expenses, lost wages, and pain and suffering. Punitive settlements, on the other hand, are meant to punish the defendant for their wrongdoing and deter similar conduct in the future.

Taxation of Medical Lawsuit Settlements

Compensatory settlements are generally not taxable, as they are meant to cover the plaintiff’s losses. However, there are exceptions, such as if a portion of the settlement is meant to compensate the plaintiff for lost wages or income.

Punitive settlements, on the other hand, are considered income and are therefore taxable. The settlement funds received must be reported as income on the plaintiff’s tax return, and taxes must be paid on the funds at the plaintiff’s regular tax rate.

It is important to note that taxes on punitive settlements cannot be avoided by structuring the settlement as an annuity or other type of deferred payment. Additionally, attorney fees and legal expenses associated with obtaining the settlement may be deductible on the plaintiff’s tax return.

Factors That Determine Whether a Medical Lawsuit Settlement is Taxable

Nature of the Claims

The nature of the claims determines whether a medical lawsuit settlement is taxable. Generally, medical lawsuit settlements that compensate for physical injuries or sickness are not taxable. On the other hand, settlements for lost wages, emotional distress, or punitive damages are taxable. The Internal Revenue Service (IRS) considers these types of settlements as income because they do not result from a physical injury or sickness.

Allegations in the Lawsuit

The allegations in the lawsuit can also affect the taxability of the settlement. If the allegations involve fraud or intentional misrepresentation, any settlement for those allegations may be taxable. This is because the settlement is not compensating for physical injuries or sickness and therefore, the IRS would classify it as income.

Structured Settlements

Structured settlements are settlements paid out over time rather than in a lump sum. Structured settlements can have significant tax advantages when compared to receiving a large lump sum. The money received in a structured settlement is taxed based on the interest earned on the payments, rather than the entire amount of the settlement. This can result in a lower tax bill overall. It is important to note that the details of the structured settlement must be carefully crafted to avoid any potential tax implications.

Types of Damages Awarded in Medical Lawsuits and Their Tax Treatment

Compensatory Damages

Compensatory damages are awarded to compensate the plaintiff for losses or injuries incurred as a result of medical malpractice. These damages include medical expenses, lost wages, loss of earning capacity, pain and suffering, and emotional distress. In terms of tax treatment, compensatory damages are generally not taxable as they are intended to make the plaintiff whole and restore them to their pre-injury financial state.

Punitive Damages

Punitive damages are awarded in addition to compensatory damages in cases where the defendant’s actions were deemed particularly egregious or reckless. Punitive damages are intended to punish the defendant and deter similar behavior in the future. In terms of tax treatment, punitive damages are generally considered taxable income and must be reported on the plaintiff’s tax return.

Loss of Consortium Damages

Loss of consortium damages are awarded to the spouse or family member of the injured party for the loss of companionship, affection, and support due to the injury. In terms of tax treatment, loss of consortium damages are generally not taxable as they are considered compensation for non-monetary losses. However, if the payment includes compensation for lost wages or other economic losses, those portions may be taxable.

Deductibility of Legal Fees Incurred in Pursuing a Medical Lawsuit Settlement

General Rules on Deducting Legal Fees

Legal fees incurred in pursuing a medical lawsuit settlement are generally deductible. However, the deductibility of these fees depends on several factors, such as the nature of the lawsuit and the type of compensation received. In general, legal fees related to personal injuries or a wrongful death are deductible.

Deductible Legal Fees for Medical Expense Claims

If the medical lawsuit settlement involves compensation for medical expenses, the legal fees incurred in pursuing this type of claim are usually deductible as a medical expense. However, the deduction is subject to the threshold of 7.5% of adjusted gross income (AGI) for tax year 2021. For example, if your AGI is $100,000, you can only deduct legal fees that exceed $7,500.

Deductible Legal Fees for Non-Medical Expense Claims

If the medical lawsuit settlement includes compensation that is not related to medical expenses, such as lost wages, emotional distress, or punitive damages, the legal fees incurred in pursuing these claims are typically not deductible as medical expenses. Instead, they may be deductible as miscellaneous itemized deductions subject to the 2% AGI floor. However, with the introduction of the Tax Cuts and Jobs Act of 2017, miscellaneous itemized deductions have been suspended until 2026.

Important Considerations for Reporting Medical Lawsuit Settlements on Your Tax Return

Timing of Settlement and Tax Year

It is important to note the year in which you receive the settlement as it will impact your taxes. If you receive the settlement in one lump sum, it will be taxed as income for the year that it was received. However, if the settlement is received over a period of years, it will affect your tax liability during each year of receipt.

Legal Fees and Taxes

Typically, any legal fees paid in relation to the settlement are deductible on your tax return. However, there may be limitations and requirements for deducting legal fees, so it is best to consult with a tax professional. Additionally, depending on the type of settlement, some or all of the settlement amount may be taxable. This can occur if the settlement includes punitive damages or interest.

Qualified Settlement Funds

In some cases, the settlement may be paid into a Qualified Settlement Fund (QSF). A QSF is an account set up to hold and distribute settlement funds. When funds are paid into a QSF, they are not taxable until they are distributed to the plaintiff. This can be beneficial if the plaintiff wants to spread out the tax liability over multiple years or if the plaintiff is unsure how to allocate the settlement funds at the time of settlement. However, there are specific rules and requirements for using a QSF, so it is important to consult with a tax professional or attorney to ensure compliance.

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