Paying taxes on pre-trial settlement for wrongful eviction

[mitchm]

Hi all,

My roommate and I were wrongfully evicted from our previous apartment; Good news is that we kept a very clear and well documented paper trail and after being forced out, successfully settled for $160k (35% to the lawyers, the remaining 65% split between myself and my roommate; about 50k/each gross).

There is a lot of confusion, however, over how much of our settlement money is taxable. The lawyers have been clear that neither they, nor the defendant will provide a 1099 to me, as the defendant paid the money into the law firm's settlement fund, which was then disbursed to us. They have also made clear that the settlement agreement we signed with the former landlord provides language for "some amount of tax relief."  I have done lots of research about the tax implications but am still not clear. The most basic answer I have found is that the only settlement money that would be tax-exempt is the amount that was paid out specifically for "physical pain and suffering." However, that doesn't seem to comport with the lawyers "tax relief" comment. At this point, itt seems the possibilities are:

a) The entire amount of the settlement is taxable, including my share of the lawyer's fees. This means I'd be on the hook for taxes on a total larger than what I even received.
b) The entire amount that I received personally is taxable.
c) Some portion of the amount I received personally is taxable, however there is room to argue that some portion is tax-exempt based on the categories of damages awarded. 

Just wondering what you all would advise re: how to move forward. I have never paid for an accountant and am hoping I won't have to this year, but I feel a little bit out of my depth here.

[TomTX]

Pay for an accountant with expertise in this area.

[seattlecyclone]

Generally, "all income from whatever source derived" is taxable unless an exception exists in the law. You're right that there is an exception for personal injury settlements, but I'm not aware of one that would apply in your case.

Here's a a document written for IRS tax auditors I found about this topic. It was last revised in 2011. It suggests that for a taxable settlement you would need to include the full amount of your share of the settlement in your income, before attorney's fees. It used to be that the attorney's fees (to the extent that they exceeded 2% of your income) could then be deducted as a miscellaneous itemized deduction, but these deductions were basically eliminated in the tax overhaul that took effect in 2018. Seems you would then be out of luck there. However you may want to look deeper into the "tax relief" provision of your settlement that your attorney mentioned. While I don't see any reason to believe that your settlement is non-taxable, it could be that the defendant agreed to pay any additional taxes you owe as a result of the settlement payment. Worth looking into.

Furthermore the audit guidance does seem to suggest (on page 27) that two 1099s should be filed by the defendant: one to you listing the full amount of the settlement and one to the attorney listing the full amount they sent to the attorney's settlement account.

I agree with @TomTX that this is probably worth paying for a few hours of an accountant's time to get it right.

[SeattleCPA]

Generally, "all income from whatever source derived" is taxable unless an exception exists in the law. You're right that there is an exception for personal injury settlements, but I'm not aware of one that would apply in your case.

Here's a a document written for IRS tax auditors I found about this topic. It was last revised in 2011. It suggests that for a taxable settlement you would need to include the full amount of your share of the settlement in your income, before attorney's fees. It used to be that the attorney's fees (to the extent that they exceeded 2% of your income) could then be deducted as a miscellaneous itemized deduction, but these deductions were basically eliminated in the tax overhaul that took effect in 2018. Seems you would then be out of luck there. However you may want to look deeper into the "tax relief" provision of your settlement that your attorney mentioned. While I don't see any reason to believe that your settlement is non-taxable, it could be that the defendant agreed to pay any additional taxes you owe as a result of the settlement payment. Worth looking into.

Furthermore the audit guidance does seem to suggest (on page 27) that two 1099s should be filed by the defendant: one to you listing the full amount of the settlement and one to the attorney listing the full amount they sent to the attorney's settlement account.

I agree with @TomTX that this is probably worth paying for a few hours of an accountant's time to get it right.

I agree with Seattle Cyclone's analysis. The full amount is taxed. You can't deduct the attorney's fees.

I would think the way to optimize here would be to look at all your other tax reduction gambits. Looks like you're talking $50K? Or maybe actually $75K once you gross up for the attorney fees? So maybe you want to load up your retirement accounts, HSA, etc. Maybe you want to try and smooth your income. (Could you have law firm split payments into two years thereby turning this into two years of $25K or whatever?) You might want to try and bunch deductions.

BTW, I think you're probably not really a candidate for CPA help. It's not that a tax guy can't answer the question. But either the cost will be too high for you or the price too low for the CPA. Also, kinda seems like the law firm should have dealt with this as part of their professional services.

[mitchm]

Thanks for all the advice!

The ship has sailed on getting the money paid out in 2+ installments; considered it for a bit, but didn't seem worth the hassle (hopefully I haven't cost myself thousands). On the topic of the other income smoothing options, I'm kind of a novice.

I have an employer-sponsored 403(b) which I contribute exactly enough to get the full employer match. I suppose I could contribute even more than that to meet the IRS yearly limit? I also have my own Roth IRA through Vanguard that I contribute the yearly max to. My work offers an HSA but I don't contribute very much to it as fortunately I have very good health insurance and remaining $ > $500 doesn't roll over from year to year.

Might there be any other options I'm not thinking of here?

Before fees, my cut of the settlement was around 80k. Also, in case it is a relevant detail, my income is very low. I make about 48k gross/year. Lastly, I do find it kind of strange that the lawyers have advised me that there are some options for "tax relief" but then won't give me any advice on what exactly they mean by that, except to offer a referral to an accountant they usually work with. If all of your/my research is correct, seems like I might just end up paying that accountant to tell me that the entire thing is taxable...

[SeattleCPA]

Also, in case it is a relevant detail, my income is very low. I make about 48k gross/year.

Ok, not to be disagreeable, but I think $48K for someone who's single is far from "very low." That's actually well above the median and basically at the mean:

https://www.thebalance.com/what-is-average-income-in-usa-family-household-history-3306189

One of my "hot buttons" is imprecision about incomes and wealth. It's really common to underestimate the "goodness" of your or my income... You might find this discussion of a longitudinal income survey uplifting and positive: Lifetime Earnings of the Top One Percent.

P.S. I would max your 403(b) this year and maybe do an IRA if you can and then next year again "push" some of your money into the tax-deferred space.

[mitchm]

Fair enough; that was more of within the context of what the average poster on this forum seems to be earning. I do live in a HCOL area but as I am single and have no debt, I do not want for anything (partially because I don't want much in the first place).

Is there a link or some other info you could share though re: "pushing" money into tax-deferred space. I understand maxing out my 403b this year, but how would doing so next year help in this situation? (aside from the typical benefits of saving for retirement). 

[SeattleCPA]

Fair enough; that was more of within the context of what the average poster on this forum seems to be earning.

I think that's maybe a sort of "FaceBook" effect. You know, as in everybody on Facebook seems to have more fun and live a more interesting life?

Is there a link or some other info you could share though re: "pushing" money into tax-deferred space. I understand maxing out my 403b this year, but how would doing so next year help in this situation? (aside from the typical benefits of saving for retirement).

I just meant that you can use some of the leftover money from the 2019 payout to fund bigger 403(b) contributions in 2020 and beyond.

E.g., you use some of the money in 2019 to max out 403(b)... and then you pay lots of tax because you have this big hit of income... but you still will have (say) $30K left over on January 1.

So what you do is take $10K a year and in 2020, 2021 and 2022 use that money to max your 403(b). You would have rather gotten these deductions in 2019 when you had the spike in income... but they're still worth something in 2020, 2021 and 2022.

[DavidAnnArbor]

I have a similar situation as mitchm.

I won a $10,000 settlement from Discover card over a federal anti-discrimination law (specifically, the Equal Credit Opportunity Act).
The lawyer keeps $4,500 of that, and I get $5,500.

My lawyer writes: "First, on 1099s, chances are you won't get one at all. I don't have an obligation to send one. While Discover does have that obligation, it's my experience that they won't. Second, on taxability. My understanding of the law is that the full 10k is taxable. There used to be a misc. itemized deduction for attorney's fees, but I believe that was removed with the 2018 tax law. However, I think the entirety of my fees could be deductible above the line because our case was one arising under a federal anti-discrimination law (specifically, the Equal Credit Opportunity Act). I encourage you to check out Publication 529 for a starting point there."

Publication 529 states:

Unlawful Discrimination Claims You may be able to deduct, as an adjustment to income on Schedule 1 (Form 1040), line 36, or Form 1040NR, line 34, attorney fees and court costs for actions settled or decided after October 22, 2004, involving a claim of unlawful discrimination, a claim against the U.S. Government, or a claim made under section 1862(b)(3)(A) of the Social Security Act. However, the amount you can deduct on Schedule 1 (Form 1040), line 36, or Form 1040NR, line 34, is limited to the amount of the judgment or settlement you are including in income for the tax year. See Pub. 525 for more information.

Publication 525 states:

Deduction for costs involved in unlawful discrimination suits. You may be able to deduct attorney fees and court costs paid to recover a judgment or settlement for a claim of unlawful discrimination under various provisions of federal, state, and local law listed in section 62(e), a claim against the U.S. Government, or a claim under section 1862(b)(3)(A) of the Social Security Act. You can claim this deduction as an adjustment to income on Schedule 1 (Form 1040), line 36.
The following rules apply.
• The attorney fees and court costs may be paid by you or on your behalf in connection with the claim for unlawful discrimination, the claim against the U.S. Government, or the claim under section 1862(b)(3)(A) of the Social Security Act.
• The deduction you're claiming can't be more than the amount of the judgment or settlement you're including in income for the tax year.

So what goes where on the 1040 form ?

Schedule 1 of 1040 on line 21 Other income. List type and amount - Do I list the settlement amount here and list is as a settlement ?
Schedule 1 of 1040 on line 36. - This is where I put the attorney's fee, but Line 36 is a sum of lines 23 through 35. So how am I supposed to add the attorney's fees to this line when there is no space on lines 23 through 35 to write anything down ?

[CSuzette]

I work in insurance and cut checks for a lot of settlements. If the check was cut with you and your attorneys name on it the lawyer likely gave them a W-9. The IRS then tracks to make sure the firm pays their share of the tax. If you were compensated for a loss there is no taxable event. If you were paid for lost wages there is likely some tax owed. If you received punitive damages there could be some tax owed. Usually a good lawyer would structure the release to make sure no tax is owed. The lawyer sounds slightly stupid so not sure how your release is worded. Not a CPA.

[DavidAnnArbor]

The settlement I received was because Discover closed two of my credit cards without stating why, which violates the federal Equal Credit Opportunity Act, and is considered an anti-discrimination settlement.
So it's not lost wages that I'm recovering.
I didn't actually lose any money from Discover's closure of the credit cards.
I don't know whether it's punitive damages, I don't think so, there was no court case where a judge/jury awarded me punitive damages.
It was simply a settlement between the attorneys for Discover card and my attorney.

[CSuzette]

I think you said you were awarded emotional distress which in some states is bodily injury for which no tax is owed. Since that is subjective as to what that is worth the whole settlement could go to that and no tax is owed. I don’t know what your release says. I have had my own claim for a real estate deal gone bad and I received over 100K for my out of pocket. I paid no tax but my attorney received over 60K and would pay tax on his share as income.