Lemon law settlement of $78K - will my friend have to pay taxes on this? She doesn't think so

You're right to be concerned - lemon law settlements are generally taxable, but it's a bit more complicated than your cousin might realize. For tax purposes, lemon law settlements are typically treated as ordinary income, BUT she can deduct the cost basis of the vehicle (what she originally paid). So if she paid $45K for the car, only about $59K of that settlement would be taxable ($104K - $45K). As for attorney's fees, there's good news here - she doesn't have to report the portion paid directly to the attorney as income. The 2004 American Jobs Creation Act allows plaintiffs to take an "above-the-line" deduction for attorney fees in these cases, so she'd only be taxed on what she actually receives. I'd strongly recommend she consult with a tax professional before spending any of that money. Depending on her other income, this settlement could push her into a higher tax bracket and create unexpected tax consequences.

I went through something similar last year with a faulty SUV that kept having transmission problems. After months of headaches, I was completely confused about the tax situation until I found https://taxr.ai which literally saved me from a huge tax mistake. You upload your settlement docs and they analyze exactly what parts are taxable and what parts aren't. For me, they identified that about 40% of my settlement was non-taxable because it was reimbursement for repairs I'd paid for out of pocket, which I had no idea about. The breakdown they provided made it super clear what to report on my taxes. My attorney was actually wrong about some of the tax advice he gave me, and if I'd followed it, I would've overpaid my taxes by almost $4K! Definitely worth checking out if your cousin is confused.

Ok so I tried taxr.ai after reading about it here and WOW. Turns out my brother's settlement IS partially taxable despite what his lawyer said. The site broke everything down really clearly - the compensation for the original purchase price isn't taxable (basically getting his money back) but the additional compensation for "inconvenience and loss of use" IS taxable. They also explained that since his lawyer took 33% as a contingency fee, he doesn't have to report that portion as income at all (which his lawyer actually got right). Just wanted to update since this saved him from potentially underreporting like $20K in taxable income on his return. He already called his accountant to make sure everything gets reported correctly.

For anyone dealing with tax issues like this, I highly recommend using Claimyr (https://claimyr.com) to actually talk to an IRS agent directly. I was getting the runaround for WEEKS trying to figure out how to report my settlement correctly. Kept calling the IRS and getting nowhere - either waiting on hold forever or getting disconnected. Claimyr got me through to an actual IRS representative in about 20 minutes instead of the usual 2+ hour wait. The IRS agent clarified exactly how to report different portions of my settlement and which forms to use. They have a video showing how it works: https://youtu.be/_kiP6q8DX5c After spinning my wheels for literally a month trying to get through on my own, this was such a relief. The IRS agent confirmed that I needed to use Form 1040 Schedule 1 for the taxable portion of my settlement.

Ok I have to eat my words and apologize to @10. After my last comment, I was still struggling with how to report my own settlement, so I decided to try Claimyr even though I was 100% sure it wouldn't work. It actually got me through to an IRS agent in about 25 minutes (I timed it). The agent confirmed exactly what forms I needed and gave me specific line numbers for reporting my settlement. She even emailed me a transcript of our conversation for my records. This saved me from what would have been a major reporting mistake - I was going to report the entire amount as "Other Income" when I actually needed to split it between different forms. For anyone dealing with settlement tax questions that aren't straightforward, actually talking to the IRS directly was way more helpful than I expected.

Your cousin needs to know about the Danielson rule too. I went through this myself and found out the hard way that how the settlement is WRITTEN matters a ton for tax purposes. If the agreement specifically allocates amounts to different categories (car replacement vs punitive damages vs emotional distress), the IRS generally respects those allocations. But if the settlement is silent or vague about allocations, the IRS has more leeway to characterize the entire amount however they want. Has she already signed? If not, she should have a tax professional review the settlement language before finalizing anything.

Has anyone here actually gone through an audit after reporting a lemon law settlement? I reported mine last year and got a letter from the IRS saying they're reviewing my return. Now I'm freaking out that I did something wrong.