On Saturday, 7/27/19, I will send out an email listing the tax traps with the Trump Tax Plan for disaster victims. As tough as those tax traps are, there are still some ways to strategically avoid most of the issues. (Forewarned is for-armed, though. Make sure you know what you need to do!)
One additional issue that I promised to cover in a blog, is this. The rules have also changed if you receive a settlement.
Let me set the stage. Out west, we worry a lot about forest fires, wild fires and grass fires. They can wipe out communities in a manner of hours and all you can hope to do is escape with your life and the lives of your pets. Sadly, the Camp Fire of northern California took a lot of lives. Not everyone could get out in time.
People lost their homes, their cars, everything they owned and gained PTSD symptoms for a long time to come. (The stories of escaping with your life and seeing others caught and burning alive are truly horrific.)
PG&E, the local power company, has admitted responsibility for the fire and there are already class action suits, asking for compensation for the loss.
Unfortunately, there is one more thing for them, and anyone else who has been in a disaster, to consider, tax. Since 1/1/2018 and the enactment of the Trump Tax Plan, tax law has dramatically changed the way taxes are calculated on a few key items. This is one of them.
For example, did you know that losing your house to a fire could mean you pay taxes now? That’s what the email discussed. How it could go very badly for people who aren’t planning and what you need to do to plan. Even if you weren’t in a fire or other catastrophic disaster, this is information you want to file around in case you or someone you know IS.
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Back to the issue of disaster victims who receive some compensation eventually. How is this taxed? The answer may surprise you!
Here are how the rules work for anyone who receives a judgement, award or settlement. Note: This is not just as a result of a disaster, but any kind of jury award as well.
You tax treatment will depend on the “origin of the claim.” For example, if you are fired, laid off and get some kind of “reduction in force” notice (all of which mean you aren’t working anymore) and you sue for wages, any settlement you receive is taxed as wages. However, in likelihood, you won’t be paid as an employee when you receive them. You’ll get a Form 1099 but you will need to pay the taxes as if you were an employee.
If a builder is negligent building your house, damages you are awarded may be able to be treated as a reduction in basis instead of immediate income.
There are a lot of nuances here, so make sure you get good tax advice from someone who understands this type of tax treatment.
If you receive an award for physical injuries or sickness, that is tax free. But an award for emotional distress or punitive damages is taxable.
This can create a lot of confusion when you receive awards. For example, if your emotional distress caused you to get an ulcer, is that physical or emotional? And what if you receive back wages in an award (taxable as an employee) plus an amount for the physical injury you suffered. It’s part taxable and part not taxable, but if the amount is not specified clearly, the IRS will likely consider it all taxable.
It’s not just important to have a good tax strategy after the fact when you file your tax return, but some good tax strategy ahead of time can also mean a whole lot less tax and hassle.
Now let’s talk about the elephant in the room. Attorney fees. They are no longer deductible. Before you skip over that simple statement, let’s consider what happens in the real world in claims like this.
Rarely do you pay for an attorney out of pocket. Usually there is an award your attorney takes a percentage fee for his or her work. A fee of 40% seems customary these days.
So, you are awarded $100,000 and pay your attorney $40,000. In fact, the attorney probably takes that amount right off the top and you get a check for $60,000. In the past, the amount of $60,000 is the amount that might have been taxable, non-taxable or partially taxable. Now, it’s the FULL amount of $100,000 that is most likely to be taxable according to the new definitions of what is taxable and what is not.
Yep, that’s right. You’ll receive $60,000 and pay tax on $100,000. Interestingly enough, your attorney will pay tax on the same $40,000 too. It’s double taxed by the government.
And that leads to the overriding strategy you need to employ right from the start. Everything, including tax treatment, is negotiable. Insist that you have time for a good tax strategist to review the settlement offer and help you structure a plan that will mean the least possible tax for you. Often it won’t matter at all to the defendant, but it can make a big difference to you.
Just as a final note, these agreements aren’t binding on the IRS or state taxing authorities. However, they usually give them a lot of weight when they are deciding if the treatment is correct.
If you don’t want to miss any more important tax updates, remember to register FOR FREE at https://www.ustaxaid.com/free-tax-updates/ and stay registered. We’ll take you off the update list whenever you wish, but we don’t think you’re going to want to miss this important information, especially if you’re building wealth and creating cash flow. Saving taxes. That’s what this is all about.