In contrast to compensatory damages, which are designed to compensate victims, punitive damages are designed to punish the wrongdoer. Punitive damages are often attractive from a financial standpoint because that is where the “big bucks” come from. Although unsettled previously, in 1996 Congress amended section 104 to clarify that punitive damages, whether or not related to a claim for damages arising out of physical injury or sickness, are not excludable from gross income. Consequently, there is incentive for taxpayers to allocate as much of a personal physical injury award to excludable compensatory damages. If parties to a suit fail to allocate a settlement award the IRS and courts will make their own determination using the initial complaint to help and even if the parties make an allocation, the allocation may not be respected if it did not result from adversarial, arm’s-length negotiation.
Like punitive damages, interest is gross income. Some authorities have tried to distinguish between pre-judgment and post-judgment interest but from a tax perspective they are equally disadvantageous. Thus, for example if any part of an award is deemed to be interest for the period between the physical injury or sickness and the time of recovery payment, that part is taxable. Note that the portion of attorney’s fees and costs allocable to such interest is deductible under Section 212.