Damages, whether received as a settlement or awarded by a court, can have significant tax implications for both the recipient and the payer. Navigating the complex landscape of tax law surrounding damages can be daunting, but understanding the basics is essential for individuals and businesses alike. This comprehensive guide will delve into the intricacies of how different types of damages are treated for tax purposes, providing clarity and insights into this often misunderstood area.
Damages and Taxes: A Complex Relationship
The taxability of damages depends on various factors, including the nature of the damages, the underlying cause of the legal action, and the specific terms of the settlement or award. Let’s break down how different types of damages are treated for tax purposes.
Personal Injury and Illness Damages
- Generally Non-Taxable: Compensation received for physical injuries or illnesses is typically excluded from gross income. This applies to both lump-sum payments and periodic payments. The rationale behind this tax treatment is to provide relief to individuals who have suffered physical harm.
- Reimbursed Medical Expenses: Any portion of the settlement that reimburses previously deducted medical expenses must be included in income to prevent double tax benefits.
Wrongful Incarceration and Emotional Distress Damages
- Wrongful Incarceration: Compensation for wrongful incarceration is specifically excluded from income tax. This includes damages for both physical and non-physical injuries.
- Emotional Distress: Damages for emotional distress are taxable unless they are directly linked to a physical injury or illness.
Wrongful Death Awards
- Compensatory Damages: Amounts awarded to compensate for the decedent’s physical injuries or sickness are generally not taxable.
- Punitive Damages: Punitive damages awarded in wrongful death cases are always taxable.
Employment Discrimination and Sexual Harassment Settlements
- Back Pay: Taxable as wages.
- Emotional Distress Damages: Taxable unless linked to a physical injury.
- Punitive Damages: Always taxable.
Punitive Damages
- Always Taxable: Punitive damages are intended to punish the wrongdoer, not compensate the plaintiff, making them taxable income.
Egg Donor Pain and Suffering Payments
- Taxable: These payments are considered compensation for services rendered, not damages for physical injury.
Interest on Delayed Settlements
- Taxable: Interest earned on delayed settlement payments is treated as taxable interest income.
Employer-Related Issues and Deductibility of Damages
- Damages Paid by Employers: Employers may deduct damages paid to employees as a business expense, subject to limitations.
- Fines and Penalties: Not deductible, even if paid as part of a settlement.
- Injury to Capital and Lost Profits: Damages for these losses are generally taxable as they replace taxable income or assets.
Deductibility of Attorney Fees
The deductibility of attorney fees depends on the nature of the legal issue:
- Business or Employment-Related: Generally deductible.
- Personal Lawsuits: Not deductible, with some exceptions (e.g., unlawful discrimination cases).
- Impact of the Tax Cuts and Jobs Act (TCJA): The TCJA suspended the deduction for miscellaneous itemized deductions, including most personal legal fees, from 2018 to 2025.
Out-of-Court Settlements
Allocating damages in out-of-court settlements is crucial for tax purposes. If the settlement agreement doesn’t specify the allocation, it may be necessary to refer to the original lawsuit to determine the taxable and non-taxable portions.
Conclusion
Understanding the tax implications of damages is essential for both individuals and businesses. The tax treatment of damages can be complex and depends on various factors. It’s crucial to consult with a tax professional to determine the specific tax consequences of a settlement or award. By understanding the general principles outlined in this guide, you can gain valuable insights into this area of tax law.
