Payment of a damages judgment or settlement almost always has tax consequences for plaintiffs and defendants. The appropriate tax treatment typically depends on the nature of the underlying claim or claims. Here’s an overview of the tax issues that may arise in damages litigation, along with some possible ways to improve tax results throughout the litigation process.
How do taxes impact litigation?
Taxes can have a major impact on how much a plaintiff is awarded — or how much a lawsuit ultimately costs a defendant. For example, let’s suppose a client with a marginal effective tax rate of 40% receives a $1 million damages award. If the judgment is taxable as ordinary income, the client will receive only $600,000 after paying taxes. But if the judgment is characterized as nontaxable, the client will receive the entire amount.
Most cases aren’t this simple. A case may involve multiple issues and multiple categories of damages, each with different tax implications. But a little planning throughout the litigation process can help ensure the most tax-favored outcome.
How are damages taxed?
Generally, the taxation of judgments and settlements is based on the “origin of the claim.” For example, damages for lost wages or profits are usually taxed as ordinary income. Payments of wages also may trigger payroll tax obligations for both parties. Damages for injury to a building or other capital asset might be treated as a combination of nontaxable return of capital (up to the plaintiff’s tax basis) and capital gain.
There’s an important exception for damages received on account of “personal physical injuries” and “physical sickness,” and the line between physical and nonphysical injuries isn’t always clear. When a plaintiff recovers compensatory damages in connection with an auto accident, slip and fall or other physical injury, the damages are tax-free, even if they represent lost wages or other items that ordinarily would be taxable. The theory is that the plaintiff should be returned to the original position or state that existed before the injury occurred. (Also, recovery of medical expenses is tax-free, regardless of whether an injury is physical.)
What about defendants?
It’s also important for defendants to consider the tax implications of paying judgments and settlements. Personal liabilities generally aren’t tax deductible. But businesses can usually deduct these payments as business expenses — although the deductions may be limited under certain circumstances.
For example, in litigation involving real property, a defendant may be required to capitalize rather than deduct a payment. And in certain cases involving investments, a defendant’s payment may be treated as an expense that’s deductible against only investment income.
How can attorneys plan ahead for tax issues?
You can improve tax outcomes by allocating judgments or settlements, to the extent possible, to claims that are classified as 1) tax-free or lower-taxed income to plaintiffs, and 2) tax-deductible payments for defendants. Although litigants have limited influence over the allocation of a judgment, the chances of a tax-favorable outcome may increase if you draft the complaint and develop the case in a way that supports the preferred allocation — but don’t let tax issues compromise your potential recovery.
When negotiating a settlement, the parties should discuss the tax implications of the settlement agreement and allocate the proceeds in a manner that generates the greatest tax benefits. As long as your allocation has economic substance, the courts and the IRS will generally respect it.
Tax issues are often outside of an attorney’s comfort zone. Moreover, tax rates and rules regarding deductions could change if major tax reform is passed. Fortunately, a tax advisor can help you navigate potential tax issues during litigation and develop strategies that minimize adverse tax consequences related to damages awards.