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Taxing Damage Awards
April 15 often adds insult to injury for clients who have to share a damage award with Uncle Sam. Nicole Snyder, manager for Gleason & Associates, offers insight into the tax ramifications of personal injury and corporate damage claims.
Personal Injury Awards
According to Snyder, the tax treatment of damage awards often depends on why the award was granted and whether it was granted to an individual or a business.
When individuals are granted damage awards directly related to personal physical injury or sickness, the damages are excluded from income for tax purposes. Punitive damages, however, are subject to taxation. Emotional distress awards are also taxable, minus the amount paid for medical care attributable to the emotional distress. Interest received as a component of a personal injury award is also taxable.
"As a general rule, compensation awards for sickness or injury are excludable from income, as long as the award meets certain Internal Revenue Code criteria," Snyder explains. "On the other hand, damages received for personal, non-physical injuries, such as employment discrimination damages, are subject to tax."
There are variables, however:
- When individuals are awarded more than one type of damage, the IRS generally requires a pro rata allocation unless the settlement specifies the amounts in each category.
- Attorney's fees and other expenses related to the recovery of taxable damages are generally regarded as miscellaneous itemized deductions subject to the "2 percent of adjusted gross income floor" rule and other limitations. However, some fees may be fully deductible or not deductible, depending on the claim.
Commercial Damages
Not surprisingly, the IRS treats business claims differently. Commercial
damage awards granted as part of a lost profits settlement are taxable
as ordinary income. This rule applies to business interruption awards,
liquidating damages and awards for breach of contract. Punitive and exemplary
commercial damage awards are also taxable, as is the interest received
as part of a settlement. Awards for injury to goodwill, however, are considered
a "non-taxable return of capital" to the extent that the amount
doesn't exceed the taxpayer's basis in the goodwill.
Costs associated with commercial damage claims have their own set of tax
guidelines. In general, costs incurred by the injured party in conjunction
with the recovery of commercial damages are deductible as ordinary business
expenses. The damages paid by the opposing party are also deductible,
as long as the payment is not related to costs associated with violations
of the law.
"Understanding and talking to clients about the tax implications
of a damage claim before a settlement is negotiated can help manage their
expectations," says Snyder. "But before anyone files a return,
a tax advisor should be consulted to conduct a thorough analysis of the
case, the damage claim and the award."
Excerpted from Briefly
Speaking, a complimentary newsletter published
by Gleason & Associates.
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