This is the first in a series of articles on issues surrounding the Taxation of Settlements and Verdicts. The article addresses the initial question of whether these amounts are included in gross income.
General Rule. The proceeds from a settlement or verdict are part of the taxpayer's gross income, unless the taxpayer can prove that the Internal Revenue Code provides for the exclusion of such receipts from gross income. IRC 61.
Origin of the Claim. The first step to determine the taxability of settlement or verdict proceeds is to determine the nature of the claims that were resolved or compromised. This is commonly referred to as the origin of the claim test. The critical question is: “In lieu of what were the damages awarded?”
Replacement of Wages. If compensatory damages are awarded as a replacement for income that would otherwise be fully taxable, then the damages are also fully taxable. Amounts received by an employee in lieu of payments under an employment contract are usually taxable as ordinary income, as long as they are not paid to compensate for a personal physical injury which is excludable from income in IRC Section 104(a)(2).
Replacement of Capital Property. Payments representing the replacement of capital are taxable to the extent that they exceed the basis of the replaced property, and then only as a capital gain. For example, recovery from a suit against a stock brokerage firm for losses in the value of stock.
Lost Profits. Payments for lost profits are ordinary income. For example, damage to business reputation; breach of contract; patent infringement; conspiracy to destroy a business; inverse condemnation; and, losses from negligent acts. Proceeds from an insurance policy that insures against lost profits, will also be taxable as ordinary income.
Goodwill. Where the underlying lawsuit is for injury to the goodwill of a business (a capital asset), the recovery represents a return of capital.
Damage to Property. If the payment is to compensate for the loss in the value of the physical asset, it is capital in nature. If the payment is to compensate for the loss of income from the physical asset, the payment may be taxable as the recovery of lost profits, that being ordinary income.
Overhead Expenses. Proceeds from a disability policy which pays for overhead expenses for a prolonged absence from the business are taxable as ordinary income.
Punitive Damages. Punitive damages are taxable as ordinary income, regardless of the character of the underlying claim.
Community Property. If the award is community property, only a portion may be included in the taxpayer's gross income.
Payment of Legal Fees. The portion of the award that is for attorney fees is generally considered taxable to the plaintiff if the underlying claim is taxable. See Blog article on Attorneys Fees.