Securities litigation can be a confusing, lengthy and all around stressful process. When you are finally able to get the settlement offer that you deserve, you no doubt want to move on with your life. The absolute last thing you want to worry about is getting hit with a surprise tax bill from the Internal Revenue Service (IRS).
To avoid tax problems, it is imperative that you understand exactly how securities settlements will be taxed. Specifically, you need to know why these settlements are sometimes, but not always, taxable, and how they should be reported to the IRS. Here, the experienced securities litigations attorneys at the Sonn Law Group have put together a quick guide on securities settlements and taxation.
Understanding the ‘Origin of Claim’ Doctrine
First and foremost, to understand the taxation of securities litigation settlements you must understand how lawsuit settlements and judgements are taxed as a general matter. To deal with this issue, the IRS uses the ‘origin of claim’ doctrine. This doctrine will control the tax treatment of your legal recovery. To be clear, it does not matter how you recovered compensation; settlements and judgements are largely taxed the same way.
The primary principle of the origin of claim doctrine is rather simple: The plaintiff should be put into the same position that they would have been in had that underlying misconduct in their case never occurred. In other words, the compensation that you recover should be taxed the same as it would have been taxed if you had never illegitimately lost out on any money in the first place.
For example, if a business sues for lost profits, any recovery related to those damages would be taxable. The reason for this is that profits in general are taxed. Therefore, if those profits were earned the normal way, they would have been taxed by the IRS. On the other hand, compensation for damage done to a business’s physical property (a capital asset) is not taxable. This is because the full amount of money for repairs would be needed to get the business back into the same position it would have been in had no misconduct ever taken place. There would have been no taxes owed related to those capital assets.
Taxation and Securities Settlements: It Can Get Complicated
The origin of claim doctrine may seem straightforward enough, and in many legal circumstances it is; however, in securities litigation, tax issues often become far more complex. Here, we highlight the three most important things you need to know about securities settlement tax treatment.
- Lost Interest and Lost Gains are Taxable
First, some portion of your settlement could be taxable. As was stated, if you are recovering compensation that would have originally been taxed, then that compensation will also be taxed. The clearest example of this is the recovery of lost interest.
For example, if you owned corporate bonds, and for some reason your brokerage firm’s misconduct resulted in you missing out on interest payments, then any compensation that you recover related to that loss would be taxed as ordinary income. The reason for this is that the interest (had it never been interrupted by broker misconduct) would have been taxed as ordinary income.
- Recovery of a Capital Asset is Not Taxable
Of course, in most securities litigation cases, plaintiffs are not merely going after lost interest or lost potential gains. Instead, plaintiffs are often trying to seek recovery of the ‘basis’ of their investment. The basis of your investment is a capital asset. In other words, you own it outright, and it is not subject to any more taxation.
For example, if your financial advisor drained $100,000 out of your investment account because they made unauthorized trades, then any settlement based on that loss would not be taxed. You are merely seeking compensation to get back into the same position you would have been in had the broker misconduct never taken place.
- You Must Consider What Has Already Been Claimed on Your Taxes
There is one more issue that needs to be considered, and it could make the tax question even more complicated: Did you claim any investment losses on your taxes in previous years? If so, then that fact must be considered when assessing the potential tax treatment of your securities settlement.
Ultimately, the IRS is not going to let you ‘double dip’. Your claimed losses must be accounted for. You should always work with an experienced attorney who can help ensure that your settlement is properly structured so that you are able to effectively minimize your tax obligations, without running into any trouble with the IRS.
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If you were the victim of securities fraud, you deserve full and fair compensation for your financial losses. The experienced investment fraud team at the Sonn Law Group can help. We have offices in Aventura, Miami, Orlando, Boca Raton and Houston, and we represent investors throughout the United States and Puerto Rico.