Default tax treatment when business owner gets settlement

The general presumption, or default, with respect to damages in a business related recovery is that they are attributable to lost profits. Basle v. Commissioner, 16 T.C. Memo 745 (1957). This is significant because a recovery for lost profits is typically taxed at ordinary income rates, rather than the more tax-favorable capital gains rate.

To reap the most benefit, taxpayers should attempt to allocate a recovery to capital assets (wherever possible), rather than allocate it as a lost profit. To support an allocation to goodwill or capital assets, the lawsuit must involve harm to such assets which is readily ascertainable in value. Arcadia Refining Co. v. Commissioner, 118 F.2d 1010 (1941). Then, once a taxpayer can demonstrate a capital recovery, it will be non-taxable to the extent of the taxpayer’s basis in the goodwill or assets and taxable at favorable capital gains rates to the extent that it exceeds basis.