While tax law may seem dull and irrelevant to most attorneys' day-to-day practice, in order to better serve their individual clients, plaintiffs should always keep the following five basic tax laws in mind. You as our client will be notified of this:

Attorney Fees Are Taxable

Clients need to be advised that they will be taxed on the gross amount of a judgment or settlement they may receive. This includes any attorney fees that will be paid on a contingency basis from the award. To add insult to injury, individuals are not afforded a deduction for the fees paid to their attorney, when those attorney fees are not incurred as an ordinary and necessary expense of the plaintiff's trade or business. Only a few states' laws (Alabama, Michigan and Texas) have addressed this "double-dip" by the IRS.

Awards for Personal Physical Injuries Are Exempt From Tax

Individual plaintiffs with claims for damages other than for personal physical injuries should be aware that the proceeds of any judgment or settlement will be included in their gross income. In addition to actual physical injuries, the exclusion from gross income will apply to compensatory damages received based on a claim of emotional distress or mental/emotional injury that is attributable to a physical injury or sickness.

Furthermore, tax law now makes it clear that punitive damages are not received on account of personal physical injures and therefore are not excludable from gross income.

There is a wide body of case law that should be examined with respect to awards for claims relating to emotional distress, mental anguish, discrimination, wrongful death and damage to reputation. This is particularly important to keep in mind where your client may have multiple claims.

When preparing a settlement agreement, care should be taken to make clear that the settlement is for personal physical injuries sustained by the plaintiff, in order to substantiate a claim for exclusion of an award received for personal physical injuries. However, the IRS may challenge settlement agreements where the facts and circumstances indicate that the allocation does not reflect the economic substance of the settlement.

Insurance Proceeds

In general, proceeds from life insurance policies are not included in gross income. Long-term care insurance contracts generally are treated as accident and health insurance contracts and amounts received from them (other than policyholder dividends or premium refunds) generally are excludable from income as amounts received for personal injury or sickness.

With respect to insurance claims for casualty and theft losses, if your clients are receiving insurance or other reimbursement that is more than their adjusted basis in the destroyed or stolen property, and they have a gain from the casualty or theft, this gain must generally be included in their income in the year they receive the reimbursement. You should advise your clients to consult a tax professional in order to determine whether the proceeds from an insurance policy will be included in their gross income and to what extent.

Lump Sum or Structured Settlement Payments

Careful consideration should be given as to whether a plaintiff should accept a lump sum judgment or settlement, as there could be significant tax consequences with respect to lump sum payments. As mentioned, if the award is for something other than personal physical injuries, the plaintiff will be taxed on the entire award, and the larger the award, the higher the tax bracket. By structuring the payments in the form of a structured annuity, so that they are paid out over time, your clients may be able to lower their taxes or even avoid paying taxes on both the principal and interest if generated from a structured settlement annuity with properly drafted documentation. By encouraging your clients to consult a tax professional and a financial adviser, you can help your clients to more effectively manage their awards, and get the maximum benefit of those awards, without having to pay more to the IRS.

Reporting of Awards