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What are punitive damages? What is their tax treatment?

The term “punitive damages” refers to the amount of money (or other assets) that a wrongdoer must pay to another as a form of punishment. Punitive damages are contrasted with “compensatory” damages, which are designed to compensate a victim. This distinction is important for many reasons, including for the reason that they differ in their tax treatment.

As for the tax treatment of punitive damages, the general rule is that it constitutes taxable income. However, oddly, neither the Code nor the Treasury Regulations provide any guidance as to what constitutes “punitive damages.” The IRS has give limited guidance in Rev. Rul. 85-98. Under that Ruling, where a plaintiff seeks both compensatory and punitive damages and recovers a lump sum payment, that the allocation between the two must be based on the “best evidence available.”