Lawsuit winnings and taxes

[BrandonSF]

Hello I won a small sum in a lawsuit last year. I recieved a W2 that that showed the lump sum. I confirmed with my lawyers office that I only need to pay taxes on the amount I won. Could anyone suggest how to file to reflect this?

Thanks in advance

[rjs]

Since the award was reported on a W-2, I assume it was for back wages. What is the distinction between "the lump sum" and "the amount I won"? Do you mean that part of the amount you were awarded went to pay your lawyer? If so, the amount you actually won is the full amount of the award, not just what was left after you paid your lawyer. The full amount is taxable income. The fact that you used part of your award to pay your lawyer does not make it non-taxable. (Employment lawyers, and the people in the lawyer's office, are not necessarily tax experts.) You just enter the W-2 as it is in your tax return.

However, what was the lawsuit for? If it was for unlawful discrimination, you can claim an adjustment (or "above-the-line deduction") on your tax return for the lawyer's fee, which means you would not pay tax on the amount of the fee. Officially TurboTax does not support the adjustment for lawyer's fees for an unlawful discrimination claim. It's listed in the Unsupported Calculations document. Nevertheless, it can be entered in TurboTax for 2023, but only in forms mode. Forms mode is available only in the CD/Download TurboTax software, not in TurboTax Online, so there is no way to make the entry in TurboTax Online.

Here's how to enter the deduction for attorney fees for an unlawful discrimination claim in TurboTax for 2023. In forms mode open the "Form 1040 or Form 1040-SR Worksheet" (1040/1040SR Wks). Scroll down to the Schedule 1 section (Additional Income and Adjustments to Income), then to Part II Adjustments to Income, and then to the Other Adjustments to Income Smart Worksheet between lines 23 and 24. Enter the attorney fees on line K of the Smart Worksheet. The amount will then appear on Schedule 1 line 24h, and it will be deducted from the income on your Form 1040.

Refer to IRS Publication 525 for important additional information about this adjustment.

[BrandonSF]

Thank you so much for the detailed reply. I had a consumer lawsuit against a rideshare company's background check company which mid-idtentifed me. I have confirmed with the lawyers office that I only need to pay the amount I was awarded after fee's. The 1099 shows the full amount. That was given by the company being sued and it makes sense that they would put the full amount. My question is how to file properly to reflect that I only owe the amount I actually recieved, and I think you answered that in the last paragraph. It was also a 1099, not a W2. 

[rjs]

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@BrandonSF wrote:

It was also a 1099, not a W2. 

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In your original question you wrote "I received a W2." That was misleading. Details matter.

There is no plain Form 1099. There are about 20 different kinds of 1099 forms. All 1099 forms have one or more letters after the 1099. What kind of 1099 do you have? Is it 1099-MISC, 1099-NEC, or something else? If it's a 1099-MISC, which box is the income in?

Misidentification in a background check doesn't sound like unlawful discrimination to me. IRS Publication 525, which I referenced above, says that the deduction only applies to claims "under various provisions of federal, state, and local law listed in [IRC] section 62(e)" (and a couple of other situations that clearly do not apply to you). I suggest that you ask your lawyer what the basis is for saying that the fee is not taxable. Ask the lawyer, not someone in the office who is not a lawyer. You might get some other opinions from other people here. You might also want to consult a local tax professional.

Based on your revised description, I now assume that the award was not for lost wages. If the form that you got is a 1099-NEC, and the lawsuit does qualify for the unlawful discrimination deduction, there are some additional complications in reporting it on your tax return.

[Opus 17]

[Edited: This is business damages, not personal damages.  Legal expenses are a deductible business expense.]

The lawyer is wrong.  You report the gross settlement as income.  Prior to 2018, the legal expenses were an itemized deduction subject to the 2% rule, but that deduction was eliminated.  The only exception is for recoveries for unlawful discrimination (age, sex, race, etc.).

The definition of unlawful discrimination is very broad, and depends on both federal and state law.  If you think your claim might involve unlawful discrimination, check with your attorney. https://www.americanbar.org/groups/business_law/resources/business-law-today/2022-april/tax-write-of... 

If this is a UDC case, you report the entire gross amount as income, and then you need to make a manual entry in Turbotax to take the deduction.  To make a manual entry, you must be using the program installed on your own computer from a CD or download, the manual entry can't be made in Turbotax online.

If this is not a UDC case, then the entire gross amount is taxable, sorry.  Report it as "other" or miscellaneous income.  Although this would have been self-employment income on schedule C, and subject to self-employment tax if you earned it in the course of working, I don't believe the settlement is or should be subject to SE tax, so I would not report it on schedule C, just as other miscellaneous income.

[BrandonSF]

Thank you for the reply again. I can confirm a tax expert has also confirmed that I'm only responsible to pay taxes on the amount I received. I would use them to file but they have a very high fee. Ideally I'd like to file myself. There's also a consumer tax act that has been filed somewhat recently that confirms my case would only be taxed on the lump sum that I received and not the full amount.

[BrandonSF]

To further define my lawsuit. I was misidentified and had to go down to the courthouse to clear my name. The background check company thought I was someone different and blocked me from work for about a month. The id'd me as someone with the same name but completely different description and date of birth.

[rjs · Accepted solution]

@BrandonSF 

It looks like you failed to make clear a key aspect of your situation. When you first said the background check was for a rideshare company, I was thinking of you as a customer or passenger. But when you said they blocked you from work, it made me realize that you are the driver. The money that you received is compensation for lost income from driving for the rideshare company. That means that the money IS self-employment income and IS subject to self-employment tax. So you SHOULD report it on Schedule C. It also means that you should deduct the amount you paid to the lawyer as a business expense on Schedule C, in the expenses category for "Legal and Professional Fees." That's how you avoid paying tax on that amount, and it has nothing to do with unlawful discrimination. You report the full amount from the 1099 as business income, and the amount that was paid to the lawyer as a business expense. And you don't need forms mode or any other tricks to do this in TurboTax.

[BrandonSF]

Wonderful thank you so much for the detailed explanations. I apologize that it wasn't clear that I am an employee and driver of uber rather than the passenger. I will use your great advice and get this filed today thanks so much. 

[BrandonSF]

Hi again - thanks for all the helpful information. My lawfirm is HIGHLY suggesting I use thier referral to do that part of the taxes for me. It cost over $500. I questioned that, based on the info you gave, and that turbo tax support gave. Im guessing its because they do referrals to this particular tax company. 

[Opus 17]

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@BrandonSF wrote:

Hi again - thanks for all the helpful information. My lawfirm is HIGHLY suggesting I use thier referral to do that part of the taxes for me. It cost over $500. I questioned that, based on the info you gave, and that turbo tax support gave. Im guessing its because they do referrals to this particular tax company. 

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If you have never before filed a tax return including schedule C for self-employment, it may be worth it to use a professional for the first year, provided the professional will teach you, rather then just do it for you.  Whether the particular professional is the right person for you is not something I can say, I would call a few and interview them and find the right fit.

There is also the Turbotax Online Live option, where you pay extra (still less than $500) and you can video chat with a CPA to help you.   

If you have filed a schedule C before and are comfortable with that, there is nothing extra about the lawsuit settlement that would require assistance.

[BrandonSF]

I just spoke with the lawfirm and they are limited on what tax info they can give, but they said the lawsuit would be under the catagory of FDRA - are you familiar with this? I suggested it seems more like an employee lawsuit but they couldnt confirm or not confirm this. 

[rjs]

FDRA is Footwear Distributors & Retailers of America, a trade association for the footwear industry. Did you mean FCRA, the Fair Credit Reporting Act? That's a law that regulates the use of personal information by companies. It applies mainly to credit bureaus, but I suppose it might have some provisions that apply to background checks.

I don't see the connection between the applicable law and how you report the lawsuit award on your tax return. It doesn't really matter what the legal basis of the lawsuit was. Maybe the law firm was trying to tell you that your lawsuit was not an unlawful discrimination claim. As we have discussed, there is a special tax provision for unlawful discrimination claims.

Your lawsuit cannot be an employee lawsuit because you are not an employee. You are a self-employed independent contractor. You are in business for yourself, and the lawsuit was a business matter.

In any case, you should go ahead and report the lawsuit income and the lawyer's fee on Schedule C as we have suggested, and stop trying to get tax advice from a law firm that doesn't specialize in taxes and "are limited on what tax info they can give." If you are really worried about it, go to a local tax professional of your own choosing.

[Opus 17]

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@BrandonSF wrote:

I just spoke with the lawfirm and they are limited on what tax info they can give, but they said the lawsuit would be under the catagory of FDRA - are you familiar with this? I suggested it seems more like an employee lawsuit but they couldnt confirm or not confirm this. 

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For your taxes, this is the ultimate point.

1. If this was a personal lawsuit, then the gross amount is taxable and there is no deduction for amounts paid to attorneys.

2. If this was a lawsuit in connection with your self-employment, then you report the entire gross amount as business income and you deduct the legal fees as business expenses.  The net you keep is subject to income tax and self-employment tax because it is business income.