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Tax treatment of interest from damage awards

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Typically, interest is taxable, as it constitutes income under IRC §64(a)(4). This remains true whether the interest is pre- or post-judgment by a court. The underlying reason for rule this is that the interest compensates plaintiffs for the time value of money, as opposed to any excludable physical personal injury or sickness and is therefore includable in gross income. Therefore, even where the non-interest portion of the reward is excludable from the plaintiff’s gross income under Section 104(a), the interest portion still constitutes taxable income.

What is the consequence of this? The answer is that it is critical that the parties to litigation specifically allocate payments in any settlement agreement to avoid payments being reclassified as interest. This is something best handled by a qualified tax attorney.