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I have a question regarding how a legal settlement payment should be handled for U.S. personal income tax purposes. This is a hypothetical scenario.

A plaintiff agrees to accept a cash settlement from a defendant in exchange for dismissing a pending lawsuit. The grounds of the suit are a defective vehicle. The vehicle in question was purchased several years prior and was still owned by the plaintiff at the time of the settlement, and the alleged defect was present at purchase. A 1099-MISC is issued to the plaintiff for the payment.

The simplest approach appears to be for one to report the settlement amount on Form 1040, Line 21 as Other Income. However, could one instead report the settlement proceeds as long-term capital gains? This would result in a more favorable tax liability on the plaintiff, but is it proper? I believe it would trigger an automatic IRS flag because the 1099-MISC income would appear to be unreported.

The initial thought behind this came after reading "10 Things to Know About Taxes on Legal Settlements" from Forbes:

  1. You may have capital gain instead of ordinary income. Outside of accidents or injuries, just about everything is income. However, that doesn’t answer the question of how it’s taxed. If your suit is about damage to your house or your factory, a settlement may be treated as capital gain. Even better, depending on your tax basis (basically, your original purchase price, increased by any improvements you made, and decreased by depreciation), your settlement may be treated as a recovery of basis, not income.

Researching IRS Publication 525 and IRS Tax Topic 409 provided some guidance, but not definitive answers.

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    It is probably well worth the money to see a tax professional. My take is that it really depends on your complaint and the amount of money received. I also think you will be audited, so just have everything else in order. – Pete B. Feb 6 '17 at 20:44
  • I agree. However I was looking for input more to determine the potential net value of a settlement than to file a return. The difference in tax liability is significant. – mike47 Feb 6 '17 at 22:51
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Could it be? Yes. Will it be? You need professional advice.

  • As I stated above, I agree that would be worth it. I was hoping to spur a discussion that might explain what would or would not push the answer in either direction. I didn't come to SE with the expectation it would replace a professional, I am trying to educate myself to properly asses the potential net value of a settlement. – mike47 Feb 8 '17 at 15:27
  • Safest assumption, in the absence of detailed analysis of the specific case, is to assume it will be taxed as Ordinary Income. – keshlam Feb 8 '17 at 16:27

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