Tax Treatment of Damages Awards
Attorneys need to contemplate the tax implications of damages awards for both the plaintiff and defendant from the beginning of the dispute process. For the plaintiff, a properly worded complaint or settlement agreement can lead to the exclusion of the damages from gross income or their taxation as a capital gain (rather than as ordinary income). For the defendant, a properly structured settlement can allow the deduction of damages and related legal expenses in full in the year paid. The best-case scenario for failure to recognize the tax consequences of damages awards is lost opportunities, and the worst-case scenario is a possible malpractice claim against the erring attorney.1
The tax consequences of damages are the same whether they are received in a judgment or through a settlement.2 Internal Revenue Code (IRC) § 61 mandates that all income, including damages, is taxable to the recipient.3 Plaintiffs, can, however, exclude damages from gross income in a limited number of situations. The most significant exclusion results from IRC § 104(a)(2), which allows exclusion of damages (other than punitive damages) from gross income if received for personal physical injuries or physical sickness. Less significant exclusions apply to damages received for medical care caused by emotional distress, punitive damages received under a state wrongful death statute where punitive damages are the only ...