In the area of taxing business and investment recoveries the most important distinction is between a recovery for lost profits and a recovery for damage to goodwill or other assets. A recovery for lost profits is taxable as ordinary income. It represents income that would have been taxable as ordinary income had it not been for the defendant’s actions. In contrast, a recovery for damage to goodwill or other assets can be capital, which would be taxed as basis recovery or as capital gain.
It is generally presumed that damages or settlement payments in a business context are attributable to lost profits. This is a relatively high threshold to cross. Thus, where a taxpayer cannot prove that an allocation to loss of goodwill is appropriate, the recovery will typically constitute lost profits. To reap the most benefit a taxpayer will attempt to allocate a recovery between lost profits and harm to capital. To support an allocation to goodwill, the lawsuit must involve harm to capital. To the extent the taxpayer can demonstrate a capital recovery it should be non-taxable up to the taxpayer’s basis in the goodwill. Where it cannot be shown that the injury relates to a capital asset, a recovery is likely to be treated as ordinary income. In some situations where there is an ascertainable value of the capital asset damaged or destroyed it is possible to determine what portion of the recovery constitutes damages for lost profits and what portion is for injury to capital assets.
Allocations may be found either in a judgment if recovery is pursuant to a judgment or a settlement but if the allocation is not addressed the burden is on the taxpayer to do so. The taxpayer will have to make an allocation based on the total amount sought, the various claims made, and the proof supporting those claims. An express allocation is not binding on the IRS but in most cases it has been persuasive.