What is The Tax Treatment of Damages in Litigation?

Understanding the tax implications and treatment of litigation damages, settlements and awards is critical for both plaintiffs and defendants. The basic principle is straightforward: damages received for personal physical injuries or physical sickness are generally tax-free, while most other damages are taxable as ordinary income. This distinction, codified in Internal Revenue Code (IRC) Section 104(a)(2), determines whether a plaintiff keeps the full recovery or owes significant taxes.

Types of Damages in Litigation

Compensatory Damages aim to make the injured party whole. These include economic damages (medical expenses, lost wages, property damage) and non-economic damages (pain and suffering, emotional distress, reputational harm).

Punitive Damages, sometimes called “exemplary damages” punish defendants for egregious conduct and deter future wrongdoing. These damages exceed what is necessary to compensate the plaintiff and generally require proof of malice, fraud, or reckless disregard.

Nominal Damages are token amounts (often one dollar) that vindicate a legal right when no substantial harm occurred.

Liquidated Damages are predetermined amounts specified in contracts, enforceable when they reasonably estimate anticipated harm.

Statutory Damages are specific amounts provided by law without requiring proof of actual harm, common in copyright and consumer protection cases.

Tax Treatment: The Physical Injury Rule

IRC Section 104(a)(2) excludes from gross income, as defined in IRC Section 61, damages received “on account of personal physical injuries or physical sickness.” This exclusion is narrow and requires actual physical harm.

What Qualifies: Observable bodily harm such as bruises, cuts, broken bones, or internal injuries qualifies. Damages for medical expenses, lost wages, and pain and suffering arising from these physical injuries are tax-free.

What Does Not Qualify: Following the 1996 law change, emotional distress alone is not a physical injury. Symptoms like insomnia, headaches, or stomach problems stemming from emotional distress do not constitute physical injury. Therefore, damages for employment discrimination, defamation, or harassment without physical injury are fully taxable.

The Exception: Emotional distress damages are tax-free only when attributable to an underlying physical injury. For example, emotional distress from a car accident causing broken bones would be excludable.

Specific Damage Categories

Punitive Damages: Almost always taxable as ordinary income, even when accompanying physical injury awards. The potential exception being damages awarded for wrongful death where a state statute provides only for punitive damages in wrongful death claims. In these cases, refer to IRC Section 104(c) which allows the exclusion of punitive damages.  See  IRS Tax Implications of Settlements and Judgments.

Lost Wages: Tax treatment depends on the underlying claim. Lost wages from physical injury are tax-free. Lost wages from discrimination or wrongful termination are taxable as ordinary income.

Interest on Awards: Always taxable as ordinary income, even if the underlying damages are tax-free. Interest compensates for delayed payment, not the injury itself.

Attorney’s Fees: Generally, the full recovery including attorney’s fees is income to the plaintiff, who may then deduct the fees. For physical injury cases, the entire amount including attorney’s fees is tax-free. For employment discrimination and certain other civil rights claims, IRC Section 62(a)(20) allows an above-the-line deduction preventing the fees from being trapped as unusable itemized deductions.

Employment Disputes

Employment litigation typically produces taxable income. Damages for discrimination, harassment, or wrongful termination are taxable as ordinary income unless the conduct caused physical injury. Back pay and front pay are treated as wage income for tax purposes.

Wage and hour claims for unpaid overtime or minimum wage violations result in taxable ordinary income. Severance payments and settlements resolving employment claims are similarly taxable.

Commercial Litigation

Contract breach damages are taxed based on what they replace. Damages for lost profits are ordinary income. Damages for breach of a contract to sell property may produce capital gain if the underlying asset was a capital asset according to IRC Section 1234A.

Fraud damages are typically ordinary income under the United States Supreme Court’s Glenshaw Glass decision. However, IRC Section 1016(a) provides if fraud relates to a property purchase, the damages may reduce the basis in the acquired property rather than creating immediate income.

Business tort damages for interference with contracts, trade secret theft, or unfair competition are ordinary income when they compensate for lost profits.

Partnership and Shareholder Disputes

These disputes present complex tax issues because payments may be characterized as redemptions, distributions, or damages.

Partnership Buyouts: IRC Section 736 divides payments into two categories. Section 736(b) payments for the partner’s share of partnership property generally produce capital gain. Section 736(a) payments for unrealized receivables or goodwill may be ordinary income and deductible to the partnership.

Section 751 “hot assets” (unrealized receivables and inventory) can convert what appears to be a capital transaction into ordinary income. This requires careful analysis when a partner exits.

Corporate Redemptions: When a corporation buys back its shares, IRC Section 302 determines whether the transaction qualifies for capital gain treatment or is taxed as a dividend. Complete termination of the shareholder’s interest generally qualifies for capital gain treatment. Partial redemptions must meet specific tests regarding proportionate ownership reduction.

If a redemption fails the Section 302 tests, it is treated as a dividend taxable as ordinary income (to the extent of corporate earnings) with no deduction for the paying corporation.

Damages vs. Redemption: The critical distinction is whether payments constitute damages for wrongful conduct or purchase price for the equity interest. True damages for breach of fiduciary duty or fraud are ordinary income to the recipient and generally nondeductible to the payor. Redemption payments may qualify for capital gain treatment and provide basis step-ups to continuing owners. If challenged, courts examine the substance of the transaction and therefore settlement agreements must clearly articulate the character of payments, though the Internal Revenue Service (IRS) is not bound by labels lacking economic substance.

Intellectual Property Disputes

Damages in intellectual property litigation – copyright, trademark and patent infringement – typically compensate for lost profits, reasonable royalties, or statutory amounts for infringement of copyrights, patents, or trademarks. These damages are generally taxable as ordinary income, as they substitute for royalty income or business profits the intellectual property owner would have earned.

Capital vs. Ordinary Treatment: If IP damages relate to the sale or transfer of the intellectual property itself rather than compensation for unauthorized use, they may receive capital gain treatment. For example, damages paid to settle a dispute over ownership of a patent that result in transfer of the patent rights may be treated as payment for a capital asset. However, damages for infringement of IP rights the taxpayer continues to own are ordinary income. The distinction requires examining whether the damages compensate for lost use and exploitation of the IP (ordinary income) or represent proceeds from disposition of the IP rights themselves (potential capital gain).

Property Damage

Property damage awards generally do not qualify for the physical injury exclusion. Instead, damages up to the taxpayer’s adjusted basis in the property are a tax-free return of capital. Amounts exceeding basis may be taxable gain. For business property, the character of gain (ordinary or capital) depends on the nature of the asset.

Drafting Settlement Agreements

Settlement agreements should clearly allocate damages among different claims and specify the nature of each payment. Key provisions include:

• Identifying whether any damages relate to physical injury or sickness
• Separately stating interest components
• Allocating between different types of claims (physical injury, emotional distress, lost wages, property damage)
• Specifying who bears the attorney’s fees and tax obligations
• For partnership and corporate disputes, distinguishing between redemption payments and damage awards

While the IRS is not bound by the parties’ characterization, a well-documented allocation based on the facts and litigation record will generally be respected if it reflects economic reality.

Strategic Considerations – Include Tax Counsel Before Settlement

Plaintiffs and counsel should carefully evaluate settlements on an after-tax basis. A lower gross settlement that is tax-free may be more valuable than a higher taxable settlement. Documenting physical injuries and maintaining medical records supporting the causal connection between injury and all damage elements is essential.

Defendants must properly report payments on IRS Form 1099-MISC (for payments exceeding $600) unless the damages qualify as excludable physical injury payments. Proper documentation protects against IRS penalties and disputes.

Both parties benefit from involving tax advisors early in settlement negotiations to structure agreements that achieve optimal tax results within the bounds of applicable law.

Conclusion

Understanding litigation damages before engaging in litigation, and certainly before settling a case can significantly affect the net economic outcome for all parties. Given the complexity and high stakes, coordination between legal counsel and tax advisors is essential throughout the litigation and settlement process.

This publication is intended for general informational purposes only and does not constitute legal advice or a solicitation to provide legal services. The information in this publication is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon this information without seeking professional legal counsel. The views and opinions expressed herein represent those of the individual author only and are not necessarily the views of Clark Hill PLC. Although we attempt to ensure that postings on our website are complete, accurate, and up to date, we assume no responsibility for their completeness, accuracy, or timeliness.