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Role of damage awards taxation in terminating litigation

Commonly, the tax ramifications of litigating or settling a case are not considered until after the fact. If approached in this manner, litigants and attorneys are missing a valuable opportunity to improve their position. In many instances tax treatment will have a significant and direct impact on the finances of a client. Therefore, it is preferable to undertake a tax analysis from the outset of a case. In this regard, an award or settlement is much more attractive if perhaps taxed at capital gains rates over ordinary income, or better yet, is completely tax-free. The consideration of tax consequences do not apply strictly to plaintiffs, but defendants as well. Payments may be fully tax deductible, partially deductible, or entirely non-deductible. Consequently, it is easy to see why understanding the applicable tax rules should be a prerequisite to resolving litigation.

The most enduring cannon or principle in this area is the “claims test.” The claims test dictates that the tax result of a settlement or judgment should be determined by reference to the underlying claim the lawsuit seeks to redress. At its most basic level this doctrine is trying to get at the question, “In lieu of what [are] the damages awarded?” Although outwardly straightforward the practical application can be complex. Often times this inquiry comes down to a facts and circumstances analysis and a little guess work because statutory authority covers only a few circumstances. For example, while Internal Revenue Code (IRC) section 61 provides that gross income includes “all income from whatever source derived” one must still distinguish between business injuries for lost profits, injuries to capital assets, and assets used in a trade or business.