Are Legal Malpractice Settlements Taxable?

Are Legal Malpractice Settlements Taxable?Lawyers may be liable for legal malpractice if they mishandle any type of legal claim – such as an accident claim, a divorce case, real estate matters, tax issues, or other causes. Experienced legal malpractice lawyers work with lawyers and other professionals to show that your lawyer was negligent, and that the lawyer’s negligence caused you damages. In most legal malpractice cases, the damage award is a specific dollar amount.

Forbes magazine explored whether the settlement is taxable, and what factors determine the amount of tax. For example, is the settlement taxable as ordinary income, a capital gain, or in some other manner? The determination of taxability is generally made by the Internal Revenue Service (IRS). This means your lawyer needs to convince the IRS that the settlement is not taxable or that the tax should be based on the least taxable method. The analysis depends, in part, on the underlying basis for the legal malpractice settlement. The analysis also depends on different provisions of the IRS Code.

Examples of legal settlements and tax requirements

Forbes provides the following examples:

  • A personal injury claim. The damages in, for example, a car accident case are based on the pain and suffering, medical bills, and lost income of the victim. The IRS Code excludes compensatory damages for physical injuries or illness. This means the settlement should be tax-free no matter who would have been liable – the driver, the owner of the car, or a manufacturer of defective parts. There are some exceptions: the interest on any award may be taxable, and punitive damages may be taxable.
  • A medical malpractice case. Say a surgeon fails to competently perform a surgery. The victim is entitled to her economic losses and compensation for her pain and suffering. If the lawyer fails to file the case within the statute of limitations, the settlement amount is treated the same way as the settlement of the car accident case. This means the settlement isn’t taxable – but the interest or punitive damage part of the settlement is taxable.
  • A divorce. If the divorce lawyer failed to protect his client’s interest in separate property (such as the client’s interest in a startup business), resulting in the other spouse obtaining half the value of the separate property, then the client has a legal malpractice claim against the lawyer. Whether the settlement is taxable may depend on the structure of the startup and the interest the spouse improperly obtains. If, for example, the other spouse gains stock in the startup, then whether the settlement is taxable depends on the “tax basis” of the stock and the value of the stock at the time of the settlement. The amount of the tax may vary if the stock is considered a capital gain. Other tax factors may also need to be considered.
  • An estate dispute. Due to legal malpractice, items that normally could have avoided probate may need to go through probate. A defective document may mean that certain heirs may not inherit their rightful share. Whether the settlement is taxable may depend on:
    • Who files the claim – the people who came to the lawyer for estate planning advice or the beneficiaries of the estate.
    • The type of asset the beneficiary was supposed to receive
    • Whether any state or federal taxes are due because of the legal malpractice
    • Other factors depending on the nature of the legal malpractice

Each legal malpractice is different. Whether the settlement or award is taxable requires a review by the legal malpractice lawyer handling your case.

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