Back Pay—Generally, a recovery for back pay is treated in the same manner as salary or wage payments and therefore taxable as ordinary income. However, in the context of a physical injury suit the IRS has treated even amounts attributable to wage loss as excludable under §104.
Lost Profits—Usually, if a plaintiff recovers for lost profits the recovery will be taxable as ordinary income except where the lost profits, if earned in the ordinary course, already are tax exempt.
Capital Assets—It sometimes difficult to determine whether a recovery relates to lost profits or a capital asset. In such situations the burden is on the taxpayer to show that a recovery relates to a capital item rather than an ordinary income item. When a recovery compensates for injuries to a capital asset the recovery constitutes a tax-free return of capital to the extent of the taxpayer’s basis in the harmed asset. Commonly, when there is an injury to an identifiable capital asset, recoveries in excess of basis are treated as capital gain. If the recovery is pursuant to a judgment, the judgment itself may allocate the award although the more common practice is to avoid this issue because in either instance the IRS is not bound to the determination for tax purposes. If the recovery is pursuant to a settlement, the settlement document should include an allocation, although that allocation is not itself necessary to secure the suggested tax treatment. If no basis is demonstrable, the entire amount is treated as a capital gain.