Awards & Settlements

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Related Documents:

Awards & Settlements - IRS Whitepaper (html, a large document)
Awards & Settlements (pdf, fster download)

Nearly 100% of the population including lawyers become confused with the tax aspects of money from a settlement, judgment or court award. This section is to help clarify the general opinion of the IRS and the Courts at this writing.

First I shall quote a Wall Street Journal article as an introduction:

WINNING A COURT AWARD can be surprisingly taxing.

Suppose you sue your employer for age discrimination, and a judge order the company to pay you$1 million. You agreed in advance to give one-third to your lawyer. How much of your award is subject to taxes? Curiously, the answer may depend on where you live and which federal court hears your case.

Some federal appeals courts have decided the entire award is taxable. But others have ruled differently, creating a confusing jumble that the Supreme Court may have to untangle, says Mary B. Hevener, a Washington lawyer at Weil, Gotshal & Manges. "This issue has been upsetting plaintiffs for years," Ms. Hevener says. "Nobody likes to pay taxes on damage awards, but plaintiffs especially hate paying tax on their attorneys' income."

Winners often can't claim most or all legal costs as an itemized deduction because of the alternative minimum tax and other limitations, she says.

(end of article)

This section will assist you to determine what the tax code requires, how to structure your settlement, judgment or award to offer the best tax benefits, what the risks are and the current climate for tax-free trial awards.

In general: Money received for personal injury (in some circuits this has been defined to include injury to business reputation) can be excluded from income (and the related deduction for the legal fees is irrelevant because the money received is not taxed to the prevailing party). Money received for any other reason is taxable to the recipient.

Personal Injury

Code Section 104(a)(2), regarding compensatory damages received because of physical personal injury or physical sickness, allows exclusion from income, irrespective of whether the money is received as a result of a judgment or the settlement of a claim. Damages received before August 21, 1996, courts may permit the exclusion of damages received in cases involving non-physical personal injuries, such as defamation or discrimination, and non-physical illnesses, such as emotional distress. (Memorandum: recent decisions by the courts seem to be allowing emotional distress and other psychological impairments as damages.)

Refer to: Code Section 104(a)(2), prior to amendment by the Small Business Job Protection Act of 1996, Pub. L. 104-188 (Aug. 20, 1996).

The exclusion applies to lump-sum payments as well as to periodic payments; however, punitive damages are not excludable, neither are amounts received as reimbursements for medical expenses previously deducted under Code Section 213, or payments to businesses.

: If the damage award does not list separately amounts for medical expenses, but instead lumps them together with payments made to compensate the taxpayer for pain and suffering, the entire award can be excluded, and any previously deducted medical expenses will not cause any of the award to be taxable. The result is similar if a portion of the award for physical injuries is allocated to future medical expenses. In this case, the award can be excluded from income in full, but the deduction for future medical expenses relating to the injury are disallowed until the portion of the award allocated to medical expenses is offset. Rev. Rul. 75-232, 1975-1 C.B. 94. If there is no allocation to future medical expenses, the future medical expenses may be deducted.

Non Personal Injury Awards

Compensatory damages received on account of non-personal injury claims -- whether pursuant to a judgment or in settlement -- are taxable as ordinary income if they compensate the recipient for lost profits or earnings.

However, damages or settlement proceeds constituting a return of capital or for the impairment of capital are taxable only to the extent that they exceed the basis of the property replaced, and then only as capital gain.

Whether an award or settlement payment is to be characterized as ordinary income or capital gain depends upon the nature of the underlying claim (i.e., the "origin of claim" test). If the award is for damage to goodwill (a capital asset) and not for lost income, the recovery represents a return of capital. The burden of proof is on the taxpayer to show what portion of the amount received, if any, constitutes a return of capital. Sager Glove Corporation v. Commissioner, 36 T.C. 1173 (1961).

The award can be allocated between ordinary and capital, however the taxpayer is for forced to prove the allocation and any challenge by the IRS is considered correct and the taxpayer has the burden to establish his/her position.

LOST PROFITS

If the payments received by a business -- whether pursuant to a judgment or in settlement -- are in lieu of lost profits, then they are includible in the taxpayer's gross income and are taxed as ordinary income.

This rule has been applied to payments stemming from a variety of lawsuits, including compensation for damage to the reputation of a business, breach of contract, patent infringement, conspiracy to destroy a business, inverse condemnation, and losses from negligent acts.

CAUTION: If a legal claim for lost corporate income is sold as part of a corporate sale, any subsequent settlement or judgment payments would still be treated as ordinary income to the purchaser, rather than as capital gain, even if the sale of the claim produces capital gain (or loss) to the seller. Nahey v. Commissioner, No. 99-1149 (7th Cir. Nov. 17, 1999).

Sometimes, depending upon the nature of a claim, a portion of the damages recovered will be characterized as ordinary income, and the remaining portion will be capital gain.

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