Won a Legal Settlement in 2023 - Confused About Taxation of Emotional Distress Award

Wait, I've heard that attorney fees for personal injury cases are no longer deductible after the 2017 tax changes. Is that true or does this situation qualify for an exception? I've been getting conflicting advice about this.

You're right to question this - the Tax Cuts and Jobs Act did eliminate many miscellaneous itemized deductions. However, there's an exception for attorney fees in certain cases including discrimination suits where the settlement is taxable. In this case, since it's an employment-related claim for emotional distress, the attorney fees can be deducted "above the line" as an adjustment to income, not as an itemized deduction. This is why I recommended using Schedule 1, Line 24a for the attorney fees rather than trying to itemize them. This treatment gives you the full deduction regardless of whether you take the standard deduction or itemize.

Thank you so much for the detailed explanation! Just to make sure I understand - I report the full $65,000 as "emotional distress settlement" on Schedule 1, Line 8z, and then deduct $27,200 (attorney fees + court costs) on Line 24a. One more question: does this settlement income affect my eligibility for any tax credits I normally claim, like the Earned Income Credit? I usually qualify for some credits due to my relatively low income from gig work.

You've got it exactly right about reporting the settlement and deducting the fees! Regarding tax credits, this settlement will not count as "earned income" for the Earned Income Credit (EIC) purposes, but it will increase your Adjusted Gross Income (AGI). Since many credits, including the EIC, have income-based phase-outs, the settlement could potentially reduce or eliminate your eligibility for certain credits if it pushes your AGI above the threshold limits. For 2023 filing (in 2024), if you're single with no qualifying children, the EIC begins to phase out at around $16,480 and completely phases out at about $23,000. With your settlement income included in your AGI, you'll likely exceed these thresholds, potentially making you ineligible for the EIC this year.

How accurate is it though? I've tried other tax tools before and they often miss important details. Does it actually understand the specific rules for emotional distress settlements vs physical injury settlements? Those are taxed completely differently.

I'm skeptical... can it really interpret legal documents correctly? Settlement agreements can be super complicated with all kinds of specific language about what the payment represents. Does it actually understand all the different tax treatments for different types of damages?

It's surprisingly accurate - it uses specialized algorithms specifically trained on tax law and settlement agreements. It definitely understands the distinction between emotional distress and physical injury settlements. It clearly identified that emotional distress settlements are generally taxable (with some exceptions) while physical injury settlements are usually tax-free. The system is designed to recognize specific legal terminology in settlement documents that determines tax treatment. It flagged important phrases in my documents like "non-economic damages" and "compensatory damages" and explained the tax implications of each. It also recognized exclusions that might apply, like medical expense reimbursements within emotional distress settlements.

How exactly does this service work? Do you still have to call the IRS yourself first or something? I've literally spent HOURS on hold with them before giving up.

This sounds too good to be true. The IRS is notoriously impossible to reach. I've tried calling multiple times this year about an issue with my refund and never got through. If this actually works, it would be a game changer, but I'm doubtful.

You start by going to the Claimyr website and entering the IRS phone number you're trying to call (they have the common IRS numbers listed already). Then the service navigates through all the IRS phone menus for you and waits on hold in your place. When an actual IRS representative comes on the line, you get a call connecting you directly to that person. The service is completely legitimate - it basically acts as a virtual assistant that waits on hold so you don't have to. I was skeptical at first too, but when I got that callback with an actual IRS agent ready to talk, I was amazed. It saved me from having to keep my phone tied up for hours hoping someone would eventually answer.

Thanks for that advice! My settlement papers do actually specify that the entire amount is for "emotional distress damages" and not for lost wages or punitive damages, so that's helpful. I hadn't thought about keeping extra documentation from my attorney though. Would it be helpful to get a specific letter about the tax treatment, or is the settlement agreement itself sufficient?

The settlement agreement should be sufficient if it clearly states the damages are for emotional distress. However, having a supplementary letter from your attorney that specifically addresses the tax treatment can be helpful if you're ever audited. I'd recommend asking your attorney for a brief letter confirming that the settlement represents compensation for emotional distress and not for lost wages or punitive damages. If possible, have them reference any relevant tax code sections that apply to your situation. Keep this letter with your tax records for at least seven years (the typical IRS audit window for most situations).

This is bad advice. Different types of settlements have very different tax treatments. Personal physical injury settlements are tax-free. Emotional distress settlements are taxable but not subject to self-employment tax. Lost wages are taxable as regular income. Punitive damages are taxable as ordinary income. Just putting it on "other income" without properly documenting and reporting each component could lead to paying too much in taxes or, worse, an audit. The specific instructions from the expert in Comment 1 are much more accurate.

You're right that different settlements have different tax treatments. I should have been clearer - I meant the OP should report it as "other income" and specifically label it as "emotional distress settlement" as the expert suggested, not just lump it in with random miscellaneous income. My main point was that tax software can be helpful for situations like this. TurboTax Premium, for example, has specific sections for reporting legal settlements and will guide you through the correct forms and line items based on the type of settlement. It also helps you properly deduct attorney fees in these situations. I didn't mean to suggest taking a casual approach to the documentation - keeping all records is absolutely essential.