There are certain basics principles for determining the tax effect of a judgment or settlement, including the following.
1. Settlements treated the same as judgments. In the first place, from a federal income tax point of view, it is typically irrelevant whether the lawsuit results in a settlement or a judgment. However, as a practical matter, settlements tend to offer greater tax planning opportunities because the parties to litigation have significantly greater room in coming to a mutually acceptable resolution, rather than merely accepting the judgment of the court which could result in a “tax inefficient” outcome. The confidentially of the settlement process also facilitates litigation tax planning.
2. Origin of the claim partly determines the tax result. Second, the origin of the claim test dictates that the tax result of a settlement or judgment should be determined by reference to the underlying claim which the lawsuit seeks to redress. The question to ask here is “In lieu of what were the damages awarded?” Raytheon Production Corp. v. Commissioner, 144 F.2d 110 (1944). The answer to this question determines whether a recovery should be taxed as a capital gain (or loss) or as ordinary income.
This test is straightforward in theory, but the practical application can be extraordinarily complex, often times developing into an extensive facts and circumstances analysis. As one case explained, consideration must be given to the issues involved, the nature and objectives of the litigation, the defenses asserted, the purpose for which the claimed deductions were expended, the background of the litigation, and all the facts pertaining to the controversy.” Bradford v. Commissioner, 70 T.C. 584 (1978).
3. How a recovery is “classified” partly determines its tax treatment. Tax planning for awards and settlements centers around classifying and apportioning payments into categories of income, with the most favorable tax treatment wherever possible. This is because under the Internal Revenue Code, “gross income” is defined as broadly as possible and it narrowly construes exclusions from income and deductions. Classifying into certain partitions can often result in significant tax savings. Typically, an award or settlement contains payments which compensate defendants for a number of different items, such as medical expenses, punitive damages, lost wages, and interest. In order for the tax treatment of a payment to be fully determined, considerable analysis is often necessary to classify and apportion an award or settlement into its constituent parts.
For example, classifying payments as solely punitive damages would cause full inclusion in gross income and tax to be applied at ordinary income rates, whereas classifying payments as a physical personal injury may result in full exclusion from ordinary income and no tax liability.