Awards and Settlements

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, a tax awards and settlements 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.

awards and settlements tax issuesIn most cases clients are only interested in the bottom line, “How much am I going to get?” This is not a simple question to answer because the amount depends on several factors. However, no consideration is more important than the tax consequences of different types of recovery. Whether recovery is on account of a jury award or an out of court settlement, the tax rules will apply. Seeking assistance in this area early will increase the chance of structuring the tax impact to maximize the benefits to litigants.

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There are several questions one should ask when making determinations about the taxation of judgment awards and settlement. First, what recoveries need to be reported? Second, what is the classification of the recovery funds, compensatory or punitive? Third, was there a proper allocation of funds? The answers to these questions are vital in determining tax liability.

In terms of settlement and judgments, the most important exception to the general income inclusion provision is for personal physical injuries and physical sickness under Section 104. Under Section 104, if funds are recovered on account of a personal physical injury or physical sickness then the recovery is excludable from gross income. Conversely, damages received on account of non-physical injury or sickness (i.e. defamation, age discrimination, housing discrimination, injury to personal or business reputation, etc.) are not excludable from gross income. Clearly, there is incentive to posture a recovery so that it fits under the §104 umbrella. Nonetheless, the most enduring cannon in this area is the claims test, which states that the tax result of a settlement or judgment award should be determined by reference to the underlying claim the lawsuit seeks to redress. Thus, a recovery for back pay is treated in the same manner as salary or wage payments and therefore taxable as ordinary income.awards and settlements tax lawyer

In contrast to compensatory damages, Congress has clarified 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. What’s more, if parties to a suit try to allocate more monies than is reasonable between compensatory and punitive damages the allocation will not be respected. Rather than letting the courts or IRS dictate an allocation in their favor, the better practice is to consult a professional and get it right the first time.

Another important aspect not to be overlooked is the tax effect on payors. The Internal Revenue Code does not expressly allow deductions for damages or settlement payments but assuming the requisite business nexus, defendants can deduct settlements or judgments, including legal fees with little issue. This is in relation to the general business expense provisions of section 162. However, certain conditions must be met, for example the payments must be ordinary, necessary, and reasonable.

At the Tax Law Offices of David W. Klasing in Irvine and Los Angeles, I provide aggressive representation for clients. I offer more than 20 years of focused experience handling highly complicated tax matters throughout Orange County, California, and surrounding areas. When you select my legal services, you gain the benefit of working with an experienced tax attorney and CPA for the same price. My extensive knowledge of state and federal tax codes, regulations and case law can help save you money.

For a reduced rate initial consultation, call 800.681.1295 or contact my offices online.


Questions Answered about Awards and Settlements