Find out how to structure personal injury recovery so you minimize the tax impact

Written by MLHA Team

April 8, 2021

Today, I would like to continue answering questions that I am commonly asked. Hopefully, they will be able to save you time and taxes.

So, here goes:

1. Penalty abatement

As we all know, the IRS not only assesses taxes against us but also imposes significant penalties and interest on penalties.

These penalties, and interest on penalties, can be set aside, or “abated,” if you have a reasonable excuse. The IRS has the discretion to determine whether you have a reasonable excuse and to set aside those amounts.

I am frequently asked why anyone would think an IRS bureaucrat could or even would make a determination that we had a reasonable excuse and set aside the penalty and interest.

I agree. It has been my experience that the IRS will rarely voluntarily set aside a penalty. The poor training programs within the IRS, as well as the low skill level of the IRS agents making that determination, pretty much, at least in my experience, will lead to the denial of such an application. I’ve actually had agents deny a penalty abatement claim before the hearing as to what our position was!

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The key here is to put the case procedurally in a position where that agent does not have the final word. It is therefore very important the procedural remedy you use allows for Tax Court review.

Folks, an IRS agent acts very differently if he or she is accountable to someone at a higher level who is always more educated and more experienced. They especially dislike testifying in court or dealing with someone who is well represented and cannot be bullied.

So, here is the answer. If you want to have a penalty set aside, and the interest on that penalty as well, you want to make sure you retain someone who has experience in federal tax matters and has litigation experience. And that way your hearing is held before an agent who suddenly becomes accountable and can’t bully your representative.

That definitely improves the fairness of the proceeding and the likelihood of success.

2. Personal injury recovery

I frequently receive phone calls from individuals who have received or soon will receive payments for personal injuries. This includes physical damage, emotional damage, discrimination based on age race and gender, and so on.

The question is always the same: Is their recovery subject to income tax? They are looking for a simple yes or no answer.

Unfortunately, the answer is not so simple. The internal revenue code contains a variety of statutes that govern the taxability of personal injury recoveries. The determination is dependent upon a variety of factors, including the pleadings in the case, the arbitration documents, the settlement documents, and the treatment by the individual parties.

It has been most depressing to represent a widow whose husband was killed in a car accident, the surviving children, or other family members, and have to explain to them that one-third of their recovery goes to attorneys and perhaps one-third will go to the Internal Revenue Service. Many times they weren’t expecting that kind of financial hit.

So, here’s the answer. If you are about to enter into personal injury litigation and have retained a really competent personal injury attorney, make sure that the tax considerations are front and center before the first pleadings are ever filed. The tax consequences can be much more easily structured in advance than they can be after the case is over.

I hope this is helpful information and saves you time and money.

David Leeper is a board certified federal tax attorney with 40 years of experience. He may be reached at 915-581-8748, leepertaxlawelpaso@gmail.com and leepertaxlaw.com.

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