Recipients of settlements and judgments generally worry more about the tax issues than payors do. Nevertheless, a defendant that is preparing to pay a settlement or judgment should also find the tax treatment of the payment to be important. A payment to resolve litigation should involve one or more of the following: 1) an ordinary and necessary business expense deduction; 2) a deduction as an investment expense; 3) a payment that is not deductible but must be capitalized as part of the cost of an asset; 4) a non-deductible personal expense; or 5) a non-deductible fine or penalty. The Internal Revenue Code does not expressly allow deductions for damages or settlement payments but assuming the requisite business nexus, defendants deduct settlements or judgments, including legal fees with little issue.

According to the general business expense provisions of section 162, settlement amounts related to a business are usually deductible. More specifically, if payments of damages or settlement are made in connection with the productions of income, payments are deductible under the principles of section 212. In order to be deductible under either section, the payments must meet the following requirements: 1) they must be ordinary, necessary, and reasonable expenses; 2) they must be paid or incurred during the tax year for which the deduction is sought; 3) they must be directly connected or proximately result from the taxpayer’s business, income producing activity, or investment activity; 4) the expense must be currently deductible rather than a capital expenditure; 5) the expense must not be personal in nature; and 6) the expense must be paid by the taxpayer that incurred it.

Another issue faced by payors is whether to capitalize or expense. The deductible expenditure is almost always preferable to the defendant because it generates an immediate tax benefit. If capitalization is required, the deduction is spread over multiple tax years. The general rule is that the claims test controls whether an amount is deductible.