Taxation of Damage Awards

Settlement And Judgments, Are They Taxable?

Unfortunately, many individuals and firms settle lawsuits without determining the tax consequences that may ensue from the settlement. The first time the issue comes up is either when the taxpayer prepares his or her tax return or receives a notice from the Internal Revenue Service or Franchise Tax Board assessing additional taxes as a result of the settlement.

Our firm frequently assists attorneys and clients in structuring lawsuits and settlements to minimize taxes, where appropriate. We also assist taxpayers in pursuing refund claims for taxes they have paid on damages, when their settlements were negotiated without sufficient consideration being given to the tax ramifications.

Taxable Damages - Double Taxation. When damages received as a result of litigation are taxable, a plaintiff may find himself or herself owing more in taxes then he or she actually received from the settlement. This unjust result stems from the Alternative Minimum Tax ("AMT") and the treatment of attorneys' fees in California and other states governed by the 9th Circuit Court of Appeals. The IRS and the courts treat the plaintiff as having received the entire gross amount of the settlement even though they actually only received a portion thereof. Although the IRS allows these taxpayers to deduct the attorneys' fees as an itemized expense, because of the implications arising from AMT, the taxpayers in essence are able to deduct only a small portion, if any, of the attorneys' fees paid. As a consequence, the taxpayer may end up paying more in tax than he or she actually received in the settlement, a result which makes no sense.

Not all damages are taxable. Internal Revenue Code §104 provides an exclusion from taxable income for damages received to compensate for physical injury. Emotional distress damages may also be excluded, if the stress stems from the physical injury. It is important to note that not all physical injuries qualify for non-tax treatment. The taxpayer needs to know the tax consequences before entering into any settlement and we can assist other attorneys and accountants in structuring such lawsuits to minimize taxes. Remember, how the complaint mediation brief and settlement agreement are structured is very important. The IRS will often look at a number of documents, and if there is any ability for the IRS to try and reclassify part of the award as taxable, an additional assessment will result. Our firm attempts to resolve these issues before an audit takes place or at the audit level. In other situations we have resolved these matters in favor of the taxpayer with the IRS appeals or with IRS counsel.

Some damages result in capital gains treatment. Where taxes are received in connection with a claim arising from the destruction or impairment of a capital asset (e.g. land, stocks), they should qualify for capital gains tax treatment, which offers opportunities for tax deferral, or in the case of a home, tax exclusion. Whether something is a capital asset is not always obvious - we had one case where a plaintiff received a settlement after suing her architect for failing to deliver plans for a house that could be built within her specified budget. We have found good authority in the caselaw to treat the settlement proceeds as capital in nature. This has an important effect on the treatment of attorneys' fees - they are, in effect, deducted from the settlement proceeds for tax purposes. Thus, unlike plaintiffs receiving damages taxed as income, who are taxed on the gross settlement, plaintiffs receiving damages taxed as capital gains are taxed on the net received after deduction of attorney's fees, and after deducting the cost of the capital asset in respect of which they brought their claim. In addition, in some cases, we have even been able to defer the taxes under various other provisions of the Internal Revenue Code.

The importance of tax consequences as an element of settlement negotiation cannot be overestimated. However, a good tax attorney can also help undo the tax damage where those consequences were overlooked at the settlement stage.