In Part II of our analysis of the tax consequences of a personal injury settlement or jury award, Oklahoma City tax lawyer, Travis Watkins, gives you the details on an often misunderstood issue: attorney's fees.
As we discussed in part I of this series, there is a fine (but important) distinction between awards and settlements that "arise out of" physical vs. non-physical injuries. If the injury is physical, the award or settlement is non-taxable, i.e. the amount is excludable from gross income. If the award or settlement is non-physical, it is taxable and included in gross income.
No legal fee deduction will be allowed for fees allocated to non-taxable awards or settlements. IRC Sec. 265(a). In other words, fees may not be deducted for physical injury awards and settlements. This means that if the award or settlement is taxable, i.e. it arose out of a non-physical injury, you may deduct attorney fees. If the settlement or award is partially taxable, your deduction for fees must bear out the same ratio as the the taxable portion to the overall award or settlement.
This is a tricky area, and you can bet that an insurance company is going to send you a 1099-MISC form that shows the whole lump sum of your award or settlement. It is up to you to make the proper deductions, if applicable, and report them correctly. To make matters worse, the IRS has issued a new field audit guide to make sure that taxpayers are reporting income and deductions from lawsuit awards correctly. Call me at (405)607-1192 if you are an injured person or lawsuit defendant (even a lawyer for either of these interests), and we will help you navigate this issue.